Download This PDF is a selection from an out-of-print volume from... of Economic Research Volume Title: American Economic Policy in the 1980s

This PDF is a selection from an out-of-print volume from the National Bureau
of Economic Research
Volume Title: American Economic Policy in the 1980s
Volume Author/Editor: Martin Feldstein, ed.
Volume Publisher: University of Chicago Press
Volume ISBN: 0-226-24093-2
Volume URL: http://www.nber.org/books/feld94-1
Conference Date: October 17-20, 1990
Publication Date: January 1994
Chapter Title: Monetary Policy
Chapter Author: Michael L. Mussa, Paul A. Volcker, James Tobin
Chapter URL: http://www.nber.org/chapters/c7753
Chapter pages in book: (p. 81 - 164)
2
Monetary Policy
1. Michael Mussa
2. Paul A. Volcker
3. James Tobin
1. Michael Mussa
U.S. Monetary Policy in the 1980s
The story of U.S. monetary policy in the 1980s is fundamentally a tale of
struggle and success, after a decade during which monetary policy contributed
significantly to the poor performance of the U S . economy. At the beginning
of the 1980s, a great battle was waged against the demon of inflation that had
damaged and distorted the U S . economy since the late 1960s-a battle that
was made necessary by the policies that nurtured the demon of inflation during
the preceding fifteen years, especially during the late 1970s. In the recessions
of 1980 and 1981-82, casualties from the battle ran high, with the unemployment rate rising to a postwar peak of 10.8 percent. In some areas, such as the
savings and loan industry, the dead are still being counted, and the bill for their
funerals is yet to be fully reckoned and paid. Nevertheless, despite the high
costs of battle, a substantial and necessary victory over inflation was won in
the early 1980s, and this success was sustained throughout the remainder of
the decade.
Indeed, by the end of 1989,the economic expansion that began in November
1982 was already two years longer than any previous peacetime U.S. expansion. Real GNP had risen at a 4 percent annual rate from the recession trough
and at a 3 percent annual rate from the preceding business-cycle peak. The
unemployment rate had fallen to the lowest level since the early 1970s. Except
for a temporary decline that was due to a fall in oil prices in 1986, the inflation
rate ran at a steady rate close to 4 percent for the eight-year period beginning
in December 1981.Judged by the objectives of the Employment Act of 1946“maximum employment, production, and purchasing power”-the U.S. econ81
82
Michael Mussa
omy performed quite well after the costly victory over inflation in 1981-82,
especially in comparison with its performance during the preceding decade.
Of course, economic performance was not solely determined by economic
policy, and monetary policy was not the only policy to influence that performance significantly. Moreover, some aspects of U.S. economic performance
and policy were not entirely satisfactory during the 198Os, including the persistence of relatively large budget and trade deficits and the failure to reduce
inflation below a 4 percent annual rate. Nevertheless, an overall assessment of
U.S. macroeconomic policy in the 1980s, in terms of the basic objectives of
supporting sustainable growth while maintaining reasonable price stability,
must be fundamentally favorable. The task of this essay is to analyze the significant contributions of monetary policy both to the macroeconomicproblems
confronting the U.S. economy at the beginning of the 1980s and to the generally successful record of dealing with those problems.
2.1 Assumptions and Qualifications
Monetary policy differs from most other elements of economic policy in the
United States because it is under the control of a single institution-the Federal Reserve System. The most important decisions about monetary policy are
made by the Federal Open Market Committee (FOMC), consisting of the seven
governors of the Federal Reserve System and, on a rotating basis, five of the
presidents of the twelve regional Federal Reserve banks (always including the
president of the Federal Reserve Bank of New York). Since the members of
the FOMC do not always share precisely the same views, the internal politics
of the Federal Reserve occasionally have some importance for decisions about
monetary policy.
However, within the Federal Reserve, there is general agreement about the
primary goals of monetary policy-sustainable economic growth with low inflation. On the FOMC and on the Board of Governors, the chairman is usually
able to shape a consensus supporting the policy that he favors. Unlike tax policy or expenditure policy or trade policy, authority over monetary policy is not
divided between the legislative and the executive branches, with many powerful individuals, agencies, and interests affecting the ultimate outcome. For decisions about monetary policy, economic effects rather than political consequences are usually the dominant concern. Accordingly, this essay focuses
primarily on the economic developments that influenced the conduct of monetary policy during the 1980s and on the economic effects of that policy.
Another important feature of monetary policy is that, like a military campaign, it is conducted on virtually a continual basis in real time. The FOMC
meets about every six weeks to discuss the performance of the economy and
to assess, and if necessary adjust, its monetary policy. In practice, the Federal
Reserve tends to maintain the general stance of its policy-toward tightness
or ease-for periods of many months. The analysis of monetary policy, there-
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Monetary Policy
fore, can conveniently be divided into major episodes corresponding to the
main thrust of the Federal Reserve’s policy. However, within each major episode, decisions are continually made to adjust (or not to adjust) the degree of
tightness or ease of monetary policy. The analysis of monetary policy must
also be concerned with the reasons for and consequences of these adjustments.
Because of the way in which monetary policy is conducted, much of this
essay is devoted to a chronological description of the main developments in
the U.S. economy and in U.S. monetary policy from the late 1970sthrough the
1980s. This is combined with an effort to interpret the effects that monetary
policy was having on the evolution of the economy and to assess critically
the conduct of that policy. The interpretative effort is based not on a formally
specified, statistically estimated econometric model, but rather on a broad, intuitively based understanding of how monetary policy influences the behavior
of the economy. Three important presumptions underlie this assessment of
monetary policy and should be explicitly stated, These presumptions are not
“truths” that have been rigorously established by economic theory or empirical
research. They represent my views about how monetary policy operates in the
U S . economy. They are widely shared by economic policymakers, especially
at the Federal Reserve.
First is a modified version of the classic dichotomy: monetary policy exerts
considerable influence on the behavior of the general level of prices (or the
inflation rate) over the medium term but has only limited capacity to influence
the medium or longer term behavior of real output and employment. Second,
in the shorter run of a year or two years, a tighter monetary policy that tends
to reduce inflation will also usually tend to reduce temporarily the growth of
output and employment; but it is an unstable monetary pplicy, contributing to
high and volatile inflation and to wide swings of economic activity, that impairs real growth in the longer term of five to ten years. Third, in the very short
term, given the state of the economy, a tighter monetary policy usually means
both an increase in short-term interest rates, especially the Federal funds rate,
and a reduction in the rates of growth of monetary aggregates.
Several important qualifications should be noted to these general presumptions. Once monetary policy has allowed substantial inflationary pressures to
build up in the economy, a determined effort to reduce inflation through a
tighter monetary policy may well reduce the average real growth rate looking
forward even over a medium-term period of three or four years. The presumption, however, is that, if monetary policy had more effectively resisted the rise
of inflationary pressures in the first place, real growth would have been better
(or, at least, no worse) in the longer term.
Monetary policy is not the only important factor influencing the behavior of
the price level, especially in the short term. When the relative prices of some
important commodities (such as oil) change suddenly and substantially, the
general price level moves in the same direction, pretty much regardless of the
stance of monetary policy. In the longer term, however, monetary policy can
Michael Mussa
84
Actual and Trend Real Gross National Product
4.500
4,000 3,500 -
f
3,000-
g
I
2,500 -
-0
m
2,000
1.500
I
a
'
'
I
'
1
1960
3
'
'
8
1
c
'
1970
0
'
I
1
'
9
I
1980
I
1 30
Percent Deviationfrom Trend Real GNP
1960
1970
1980
1990
Unemployment Rate
11
1960
1962
1964 1966
1968
1970
1972
1974
1976
1978 1980
1982
1984 1986
1988
1990
Year
Fig. 2.1 Output measures, 196O:l-199O:l
Note: The actual and trend real GNP is the quarterly GNP in constant 1982 dollars. Logarithmic
scale; trend calculated from Hodrick-Prescottfilter (L= 1,600).
effectively resist a persistent rise in the rate of inflation, even if it is not the
only influence on the general price level.
Monetary policy is also far from the only important factor that influences the
course of economic activity. The general slowdown in the rate of real economic
growth since the early 1970s, in the United States and other major industrial
countries, is not plausibly the consequence of monetary policy. Even for
business-cycle fluctuations in economic activity (as illustrated in fig. 2.1 by
deviations of real GNP from its smoothed trend path), many factors other than
monetary policy played important roles.' These factors include fluctuations in
government spending associated with the Korean and Vietnam wars, other important fiscal policy actions of the U.S. government, the oil shocks and other
commodity price disturbances of the early and late 1970s, some exogenous
fluctuations in consumption and investment spending, and some important
shifts in U.S. real net exports related to movements in foreign economic activity and in the foreign exchange value of the dollar. Indeed, even exogenous
fluctuations in the rate of productivity growth-the central focus of "real"
1. The smoothed trend path of U.S. real GNP in fig. 2.1 is constructed by using the HodrickPrescott filter, which allows for some gradual change in the trend rate of growth or real GNP.
There is nothing sacred about this particular filter, but it does give a generally reasonable basis for
measuring business-cycle deviations of real GNP from its trend behavior. I would argue, however,
that the trend line is probably a little low during 1980-83. The 1980 recession should push real
GNP somewhat further below the trend line, and the 1981-82 recession should be reflected in a
somewhat larger reduction of real GNF relative to trend.
85
Monetary Policy
business-cycle theories-probably played some meaningful role in postwar
U.S. business cycles.
Monetary policy, however, was surely one important factor that influenced
the course of economic activity during the recessions of 1957-58, 1960-61,
1969-70, 1974-75, 1980, and 1981-82, as well as during the growth slowdowns of 1966-67 and 1989-90. Given the longer-term movements in the
trend rate of real economic growth, monetary policy also influenced the specific course of economic activity during postwar business-cycle expansions.
Discerning the effects of monetary policy on the price level and on economic activity is a difficult and somewhat imprecise task because these effects
are not always stable from one episode to the next. Experience suggests that a
tightening of monetary policy should be expected to slow real growth with
a lag of a few months to a year or so and to slow the rate of inflation with a
somewhat longer lag and conversely for an easing of monetary policy. However, a good deal depends on the context in which a monetary policy action is
taken and on the effect of that action on expectations. In a strongly growing
economy, monetary tightening may have little short-term effect on real economic activity, while, in an already weak economy or in combination with
other negative shocks, a sharp monetary tightening may rapidly induce an economic downturn. If economic agents are highly sensitive to the risks of rising
inflation, and if the central bank lacks credibility for its anti-inflation policy,
a relatively minor action to ease monetary policy may stimulate a rapid and
significant inflationary response. In contrast, if the monetary authority has established a high degree of credibility for its opposition to inflation, and if conditions in the economy are relatively slack, then even a substantial easing of
monetary policy may take considerable time to generate significant inflationary results.
The interpretation of what constitutes a tightening or an easing of monetary
policy also can be a complex and sensitive matter. An action to raise the Federal funds rate that would normally signify monetary tightening may not have
this significance if increases in inflationary expectations or other pressures on
market-determined interest rates are pushing rates up faster than the action of
the monetary authority. Conversely, a sharp slowdown in money growth that
would normally indicate monetary tightening (especially in a rapidly expanding economy) may not have quite the same significance if economic activity is falling in the initial stages of a recession. More generally, it should be
recognized that changes in monetary growth rates and in the Federal funds rate
reflect both policy actions of the Federal Reserve and endogenous responses
to other developments in the economy.
With all these qualifications, it may be wondered whether it is possible to
reach firm conclusions concerning the successes and failures of monetary policy during the 1980s. On the several important issues, I believe that reasonably
clear answers can be given. Fortunately, these answers do not require precise
estimates of the effects of monetary policy, and of the effects of all other fac-
86
Michael Mussa
tors, on the performance of the U.S. economy during the 1980s. Instead, it is
a great advantage to assess the conduct of monetary policy qualitatively, by
examining whether an alternative course of monetary policy would plausibly
have improved the performance of the U.S. economy and whether the Federal
Reserve ought reasonably to have had the sense and judgment to pursue such
an alternative policy. Inevitably, of course, a significant degree of ambiguity
will always remain in any such effort to assess fairly the complex and difficult
task of conducting monetary policy in the U.S. economy.
2.2 Nurturing the Demon of Inflation
To analyze the most important issue in the conduct of monetary policy during the 1980s-the battle against and victory over high and volatile inflationit is essential to review the development of the problem of inflation during the
postwar era.
2.2.1 The Rise of Inflation
The inflation rate, measured by the annual rate of change in the Consumer
Price Index (CPI), remained quite low from the early 1950s through the mid1960s. Indeed, in 1956, the Federal Reserve became concerned when the inflation rate rose to 3 percent. The consequent tightening of monetary policy
probably helped precipitate, deepen, or prolong the recession of 1957-58.
After remaining at or below 2 percent through 1965, the inflation rate rose
to 3.4 percent during 1966. Concerned with possible overheating of the economy, the Federal Reserve tightened credit for about six months during 1966.
There was a brief slowdown in economic growth in late 1966 and early 1967,
but no recession. The inflation rate in 1967 leveled off at about 3 percent.
However, with the resurgence of economic growth beginning in the second
half of 1967 and the deepening U.S. military involvement in Vietnam, the inflation rate rose to 4.7 percent during 1968 and to 6.2 percent during 1969.
Concern with high inflation brought a tightening of both monetary and fiscal
policy beginning in late 1968-policy actions that surely contributed to the
recession that started in late 1969. In contrast to the 1950s, however, the inflation rate reached 6 percent before effective policy measures began to operate
against the inflationary menace.
Under the impact of rising unemployment and declining economic activity,
the inflation rate (measured by the six-month annualized rate of change in the
CPI) fell to 5.2 in late 1970 and continued down to about 3.5 percent during
the first half of 1971. About six months into the recession, with evidence of no
more than a partial victory over inflation, the Federal Reserve began to ease
monetary policy fairly aggressively. Business activity began to expand in November 1970.
During the summer of 1971, monthly inflation rates began to edge upward.
On 15 August, President Nixon imposed wage and price controls. For the next
87
Monetary Policy
year and a half, these controls helped partially suppress a further rise of the
inflation rate, despite a relatively easy monetary policy. As controls were
phased out, however, the inflation rate began to rise. With the increase in world
oil prices after the Arab-Israeli War of October 1973, the twelve-month inflation rate was pushed to 8.7 percent for 1973 and to 12.3 percent for 1974inflation rates well above the 6.2 percent rate at the end of the long economic
expansion of the 1960s.
The Federal Reserve began to raise the Federal funds rate in response to
rising inflation in late 1972, but growth rates of monetary aggregates remained
relatively robust until more aggressive actions to tighten monetary policy were
undertaken beginning in mid- 1973. These actions, together with other effects
of the rise in world energy prices, helped bring an end to the expansion of the
early 1970s. The cyclical peak for this expansion is officially placed at November 1973. However, owing partially to a speculative buildup of inventories, the
sharp phase of economic downturn did not start until the late summer of 1974.
As economic activity plummeted during the final quarter of 1974 and the
first quarter of 1975, the inflation rate also dropped sharply. The nearly complete absorption of the price level effects of the increase in world energy prices
by early 1975 was presumably another important contributor to the decline of
inflation. In any event, the inflation rates for 1975 and 1976 were 6.9 and 4.9
percent, respectively. This drop in inflation was a significant accomplishment
relative to the high inflation of 1973-74. However, it still left the inflation rate
at the end of the deep 1974-75 recession above the rates at the ends of earlier
recessions.
2.2.2
Targets for Monetary Growth
In the spring of 1975, at the behest of Congress and over objections from
the Federal Reserve, the FOMC began to announce its intentions for monetary
policy by specifying growth rates for monetary aggregates. At the beginning
of each year, target ranges were specified over the subsequent four quarters for
the growth rates of three monetary aggregates: (old) M1, consisting of currency and demand deposits at commercial banks; (old) M2, consisting of (old)
M1 plus time deposits at commercial banks; and (old) M3, consisting of (old)
M2 plus deposits at savings banks, savings and loan associations, and credit
unions. As a shorter-term guide for monetary policy, the FOMC also determined target growth rates for these three monetary aggregates during the coming quarter.
The target growth rates for monetary aggregates were not the operational
guide to the actual conduct of monetary policy. At each meeting of the FOMC,
operational guidance for monetary policy is provided in the directive to the
manager of the Open Market Desk at the Federal Reserve Bank of New York.
Since the early 1970s, this directive had made reference to growth rates of
monetary aggregates as one of the concerns of the FOMC that should be taken
into account by the manager of the Open Market Desk. However, the directive
88
Michael Mussa
provided the critical guidance for the operational conduct of monetary policy
by specifying a target range for the Federal funds rate.
The Federal funds rate is the interest rate on reserves lent between banks
that are members of the Federal Reserve System and certain other participants
in the market for “immediately available funds.” The manager of the Open
Market Desk at the Federal Reserve Bank of New York directly influences the
Federal funds rates by open market operations that increase or reduce the supply of immediately available funds that may function as bank reserves. During
the 197Os, the monetary policy directive from the FOMC usually instructed
the manager of the Open Market Desk to maintain a specific value of the Federal funds rate provided that the monetary aggregates appeared to be growing
within their desired short-term ranges. If the growth rates of monetary aggregates appeared likely to breach their desired short-term target ranges, the manager was usually authorized to make marginal adjustments to the Federal funds
rate within a narrow tolerance range. This tolerance range was occasionally as
wide as a percentage point, especially during 1975-76, but was usually limited
to half a percentage point or less. Sometimes the language of the FOMC directive indicated a quite specific value for the Federal funds rate. At other times,
the manager was instructed to use somewhat more discretion in adjusting the
Federal funds rate in the light of economic developments.
The manager was generally instructed to seek further guidance from the
FOMC if adjustments of the Federal funds rate outside its narrow tolerance
band appeared necessary to contain monetary growth rates within their desired
short-term target bands. In such situations, the FOMC might decide to alter
(explicitly or implicitly) its monetary growth targets and avoid changes in the
funds rate. Moreover, at any time, the FOMC could alter either its monetary
growth targets or its prescription for the Federal funds rate if that appeared
desirable in the light of information about the actual and prospective performance of the economy.
2.2.3
Recession and Recovery
During the recession of 1974-75, as the U.S. economy experienced sharp
declines in both real output and inflation, the Federal funds rate was reduced
rapidly from its peak of 13 percent in July 1974 to 5 percent in late May 1975.
This decline in the funds rate both represented the normal monetary policy
responses to developments in the economy and mirrored the substantial declines in other short-term interest rates. The sharp decline in market interest
rates, in turn, reflected both the credit market effects of the drop in economic
activity and the substantial decline in the actual and expected rate of inflation.
In the summer of 1975, as evidence of economic recovery accumulated, and
as short-term interest rates moved modestly higher, the Federal funds rate was
raised to 6.3 percent by late September.2Subsequently, as data indicated that
2. In this essay, the description of economic conditions that provided the context for decisions
about monetary policy by the Federal Reserve is generally based on the official “Record of the
89
Monetary Policy
M1 and M2 were growing below the lower limits of their desired target ranges,
the FOMC directed a series of reductions in the Federal funds rate down to
4.87 percent in January 1976. In May 1976, with indicators pointing to continued vigorous recovery, and with M1 and M2 now growing above their target
ranges, the Federal funds rate was raised briefly to 5.5 percent and then held
in the range between 5.25 and 5.5 percent through the summer months. During
the autumn, amid signs of moderating real growth, with the monetary aggregates apparently growing within their short-term target ranges, the Federal
funds rate was eased downward to 5 percent in early October and to 4.6 percent
by late December. As the year ended, M1 was at the midpoint, and M2 and
M3 were marginally above the upper limits, of the longer-term target ranges
established a year earlier.
By the end of 1976, there was some evidence that inflation might be rising,
while economic growth appeared sluggish. On balance, the evidence at this
stage does not indicate that the Federal Reserve was knowingly fueling the
resurgence of inflation. However, it may fairly be said that the Federal Reserve
was not demonstrating much resolve to continue progress toward reducing inflation below the level that had led to the introduction of wage and price controls in August 1971.
2.2.4 Falling behind the Curve
During 1977, economic expansion proceeded rapidly, especially during the
first half, while the twelve-month rate of consumer price inflation rose from
4.9 percent in December 1976 to 6.7 percent in December 1977. The Federal
Reserve attempted to signal an effort to contain inflationary pressures by reducing, by half a percentage point, the upper and lower limits on the target
growth ranges for monetary aggregates. The Federal funds rate was raised by
three-quarters of a percentage point by midJuly and by an additional 1.25
percentage points by year’s end.
The seriousness of these efforts to combat the rise of inflation during 1977,
however, is open to question. The Carter administration’s number one priority
for economic policy was to maintain a vigorous expansion that would bring
substantial reductions in the unemployment rate. The administration made
clear that it did not favor a monetary policy that would interfere with this objective. On Capitol Hill, especially among Democrats, who dominated both
Policy Actions of the Federal Open Market Committee,” which is published periodically in the
Federal Reserve Bulletin and is reproduced each year in the Annual Report of the Board of Governors of the Federal Reserve System. Quite often, revised data provide a somewhat different picture
of the performance of the economy than the Federal Reserve had at the time of its decisions. When
this is a factor of substantial importance, it will usually be mentioned in the text. Where the issue
is not important, revised data (rather than data available at the time) are sometimes used in this
essay. The figures in this essay are all constructed with the most recent, revised data. It is important
to recognize that the image presented by these figures does not always correspond to the information that the Federal Reserve had available at the time.
90
Michael Mussa
houses of Congress in the aftermath of Watergate, there was little sympathy
for fighting inflation at the expense of progress in reducing unemployment.
In this political environment, the Federal Reserve authorized increases in
the Federal funds rate only after evidence pointed to continued strong economic growth and only when the growth rates of monetary aggregates exceeded the shorter-term targets set by the FOMC. Despite a cumulative increase of 2 percentage points in the Federal funds rate, M1 grew by 7.8 percent
from the fourth quarter of 1976 to the fourth quarter of 1977-2 percentage
points higher than M1 growth for 1976 and 1 percentage above the upper limit
of the target growth range for M1 for 1977. For M2 and M3, growth during
1977 was about 1 percentage point below growth during 1976, but at the upper
limits of the target growth ranges for the aggregates.
In 1978, economic growth remained quite vigorous, while inflation
worsened considerably. Specifically,real GNP rose by 6.3 percent on a fourthquarter-to-fourth-quarterbasis, while the twelve-month rate of consumer price
inflation increased from 6.7 percent in December 1977 to 9.0 percent in December 1978. The target ranges for monetary growth in 1978 were set somewhat lower than for 1977, and the actual growth rates of M1, M2, and M3 were
reduced from their 1977 growth rates. However, as in 1977, M1 grew above
the upper limit of its target range, and M2 and M3 grew near the upper limits
of their ranges.
On several occasions during 1978, the FOMC responded to the worsening
inflation and to the rapid growth of monetary aggregates by raising the Federal
funds rate, from around 6.5 percent in early January to 8.75 percent by late
September, and ultimately to 10 percent by year’s end. In April, the Carter
administration signaled the increased priority that it assigned to curbing inflation when the president announced a variety of measures directed at that objective. At its meeting on 18 April 1978, the FOMC indicated the increased concern that it felt about rising inflation by reordering the official statement of its
objectives in the directive to the manager of the Open Market Desk, placing
“resisting inflationary pressures” ahead of “encouraging continued moderate
economic expansion.”
Despite the actions and statements of the administration and the Federal
Reserve, by September 1978 it was clear that the efforts to combat rising inflation were not succeeding. At the end of the third quarter, virtually all measures
of inflation were running significantly above their year-earlier levels. M1 was
running well above the upper limit of its longer-term target range, and M2 and
M3 were at the upper limits of their ranges. In October 1978, the U.S. dollar
came under heavy downward pressure in foreign exchange markets, indicating
a worldwide crisis of confidence in the ability and willingness of U.S. authorities to take effective action to control inflation.
2.2.5 A Failed Effort at Control
On 31 October and 1 November 1978, the administration and the Federal
Reserve took action to deal with the crisis. The Treasury announced a variety
91
Monetary Policy
of measures to acquire substantial amounts of foreign currencies with which
to intervene in support of the dollar in foreign exchange markets. The Federal
Reserve Board raised the discount rate by a full percentage point to 9.5 percent and established a supplementary reserve requirement for time deposits
of over $lOO,OOO. The tolerance range for the Federal funds rate was raised
from between 8.75 and 9.25 percent to between 9.25 and 9.75 percent.
During the final two months of 1978, the growth rates of the monetary aggregates slowed considerably but remained above or near the upper limits of
their longer-tern growth ranges. The FOMC directed a marginal increase in
the Federal funds rate to 10 percent, partly to support the dollar in foreign exchange markets and partly to enhance the credibility of its efforts to combat
inflation.
The statement of Federal Reserve objectives for monetary policy in 1979
made it clear that reducing inflation was the number one priority. The target
growth ranges for (old) M2 and (old) M3 were set at 5-8 percent and 6-9
percent, respectively-a 1 percentage point reduction in the maximum desired
growth rate and a 1.5 percentage point reduction in the minimum desired
growth rate from the 1978 monetary growth targets. Anticipatingthat the introduction of automatic transfer service (ATS) accounts would reduce the growth
of demand for (old) M1 by 3 percentage points because of shifts from demand
deposits to savings deposits, the target range for (old) M1 was set at 1.5-4.5
percent.
During 1979, inflationary pressures generally rose, while real economic activity followed an erratic and perplexing course. The increase in world oil
prices, subsequent to the overthrow of the shah of Iran, contributed significantly to the increase in inflation. Specifically, the energy component of the
CPI showed a 37.4 percent increase during 1979, compared with an 8.0 percent
increase during 1978, and this helped raise the overall inflation rate from 9.0
to 13.3 percent. Even excluding energy prices, however, the rate of increase in
the CPI escalated significantly from 9.2 percent during 1978 to 11.1 percent
during 1979. Other measures of inflation, such as the rate of increase in the
GNP price index or in average hourly earnings, also showed significant increases for 1979 over 1978. Moreover, most measures of inflation (except average hourly earnings) tended to show higher inflation rates as the year progressed-a
disturbing development that surely increased fears of future
inflation.
After registering an unexpectedly strong advance at the end of 1978, economic activity was believed (at the time) to have turned quite sluggish in early
1979. Specifically, it was estimated that real GNP grew at a rate of less than 1
percent during the first quarter. Incoming evidence during the spring and summer pointed increasingly to an economic downturn. By the 11 July meeting of
the FOMC, it was clear that economic activity had declined during the second
quarter, and further declines were widely anticipated. Indeed, the record of that
meeting indicates that “no member of the Committee expressed disagreement
with the staff appraisal . . . [suggesting] a further contraction in economic ac-
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Michael Mussa
tivity over the next few quarter^."^ Ultimately, revised data would show that
economic activity was essentially flat during most of 1979, with moderate
growth occurring during the summer quarter and again during the first quarter
of 1980. However, as events unfolded during the course of 1979, it was generally believed, at the Federal Reserve and elsewhere, that a recession was either
in progress or about to begin.
During the first half of 1979, monetary policy held the Federal funds rate
nearly constant, in a narrow range between 10 and 10.5 percent. During the
first quarter, (old) M1 declined, while (old) M2 and (old) M3 grew at rates
below the lower limits of their target ranges. During the second quarter, growth
of all the monetary aggregates picked up considerably, and, by early midsummer, each of these aggregates had reached or exceeded the upper bound of its
target range. On 20 July, the Board of Governors raised the discount rate half
a percentage point to 10 percent. On 27 July, the FOMC raised the upper limit
of the Federal funds rate from 10.5 to 10.75 percent. On 14 August, the FOMC
directed that the Federal funds rate be raised to an average of 11 percent and
maintained within a band of 10.75-11.25 percent. On 16 September, the
FOMC directed a “slight increase in the weekly average federal funds rate to
about 11.5 percent.”
This action raised the Federal funds rate in late September 1979 to 1.5 percentage points above the level it had reached just after the dollar stabilization
crisis in November 1978. In the face of what was believed to be a very weak
economy, most probably an economy already in recession, the FOMC believed
that this was the appropriate degree of monetary tightening to combat clearly
rising inflationary pressures? The economy, however, was not as weak as was
believed at the time. More important, while the Federal funds rate had been
pushed up 1.5 percentage points during the ten months ending in September
1979, the inflation rate had risen by more than double that amount. Also, the
monetary aggregates had risen from below the lower limits of their target
ranges in March 1979 to or above the upper limits of those ranges by September. Once again, the Federal Reserve was falling behind the curve in its efforts
to combat rising inflation. The foreign exchange market provided a further
signal of this fact as the dollar once again came under severe downward pressure during the summer of 1979. Thus, eleven months after the administration
and the Federal Reserve dramatically announced their new policies to curb
inflation and strengthen the dollar, it was clear that those policies were not succeeding.
3. Unless otherwise indicated, most of the quotations in this essay are taken from the official
“Record of the Policy Actions of the Federal Open Market Committee” (see no. 2 above). Several
quotations, however, come from the semiannual “Monetary Policy Reports to Congress,” which
are also published in the Federal Reserve Bulletin and in the Annual Report.
4. A majority of the FOMC certainly may be said to have held this view. However, some members of the committee (especially Henry Wallich and, on one occasion, Paul Volcker) dissented
and expressed their preference for a tighter monetary policy to combat inflation despite signs of
economic weakness.
93
Monetary Policy
Of course, the acceleration of inflation during 1979 was partly the consequence of the second oil price shock that followed the overthrow of the shah
of Iran. Had events developed differently, had the economy actually entered a
recession in 1979, then perhaps the efforts to reduce inflation would have
proved more successful. Moreover, it is understandable that the Federal Reserve was reluctant to take decisive action to tighten monetary policy when it
faced the dreaded dilemma of rising inflation together with an economy that
appeared to be in, or on the verge of, recession.
2.2.6 The Heritage of Rising Inflation
The dilemma that confronted the Federal Reserve in 1979 was not exclusively, or even primarily, the product of political upheaval in Iran and the second oil shock. In substantial measure, it was the consequence of failures to
confront the rise of inflationary pressures more consistently and effectively at
an earlier stage. Other countries, notably Switzerland and West Germany, that
pursued more determined efforts to reduce inflation after the first oil shock in
1973 did not see their inflation rates rise as high in 1979 as in 1974-75. In
contrast, the United States, which pursued a more laissez-faire policy toward
inflation, confronted the second oil shock with inflation already rising through
9 percent and saw inflation jump to new peaks during 1979.
Moreover, the failure of U.S. monetary policy to curb the rise of inflation
during the late 1970scannot be explained away on the grounds that the Federal
Reserve could not reasonably have understood the consequences of its actions.
The failure is apparent not only in the persistent rise of inflation but also in the
general tendency for monetary growth to exceed the targets set by the Federal
Reserve. Specifically, as shown in figure 2.2, growth of M1 significantly exceeded the upper bound of its annual target range in 1977, 1978, and 1979. In
1975, M1 ended the year at the lower limit of its target range. This result,
however, was largely the consequence of slow growth of M1 early in the year,
attributable primarily to continued decline in economic activity and to the
more rapid than anticipated decline in the rate of inflation. Only during 1976
was the growth of M1 close to the midpoint of the range set by the Federal Reserve.
For M2, as illustrated in figure 2.3, the story is worse. Only in 1978 was the
growth of M2 close to the midpoint of its target range. In 1979, M2 growth
was at the top of the target range, and, in 1975, 1976, and 1977, it was significantly above the upper limit of the target range. Moreover, for both M1 and
M2, the Federal Reserve followed the practice of “rebasing” its monetary targets each year for the monetary growth that had actually occurred the preceding year. If the Federal Reserve had been effectively resisting the rise of inflation, this practice might have been defensible as a means of accounting for
unanticipated shifts in money demand. In the circumstance of persistently rising inflation in the late 1970s, however, the practice of rebasing amounted to
monetary accommodation of accelerating inflation.
94
Michael Mussa
"I
420
400
P 360
-
0"
0
E
'
340 -
-
320 300 -
z8
260 1975
1976
1977
Year
1978
1979
1980
Fig. 2.2 M1 and growth target ranges, January 1975-December 1980
Note: The monetary targets are those established by the FOMC at the beginning of each year for
annual growth rates.
1.800
8001
I
1975
1976
1977
1978
1979
1980
Year
Fig 2.3 M 2 and growth target ranges, January 1975-December 1980
Note: The monetary targets are those established by the FOMC at the beginning of each year for
annual growth rates.
95
Monetary Policy
-20
1
-51'
1975
"
1976
1977
'
1978
15
'
1979
1
1980
'
1981
"
1982
1963
"
1984
1985
'
1986
"
1987
1988
1
1989
1
1990
I
Dltference between Federal Funds Rate and Inflation Rate
I
10
1975
1976
1977
1978
1979
1980
1981
1982 1983
Year
1984
1985
1986
1
1987
1988
1989
1990
Fig. 2.4 Inflation rate and interest rate, January 1975-April 1990
Note: The inflationrate is a six-month moving average of the growth of the seasonally adjusted
CPI,all items.
The inadequacy of the Federal Reserve's efforts to curb inflation during this
peribd is also apparent in the behavior of the Federal funds rate, as illustrated
in figure 2.4. The Federal funds rate was raised gradually from early 1977
through 1979. However, these increases in the Federal funds rate often lagged
behind increases in the inflation rate, indicating fairly clearly that the Federal
Reserve was "falling behind the curve" in its actions to combat rising inflation.
To observers outside the Federal Reserve, the developments of the late 1970s
indicated that U.S. monetary policy was not deeply committed to resisting the
rise of inflation. Most important, the actual inflation rate was rising persistently, even before the second oil price shock. Monetary growth was generally
allowed to exceed announced targets. New targets were rebased to accommodate past inflation and past excessivemonetary growth. Increases in the Federal
funds rate often lagged behind increases in the inflation rate. Thus, while the
Federal Reserve talked about a battle against the demon of inflation, it gave
little evidence of much stomach for the fight.
2.3 The Demon Wins Another Round
Paul Volcker replaced G. William Miller as chairman of the Federal Reserve
Board on 6 August 1979.For the preceding four years, Volcker had been president of the Federal Reserve Bank of New York and hence a member of the
Federal Open Market Committee. Earlier, he had served in the Nixon administration as undersecretary of the Treasury for monetary affairs-traditionally
a position of considerable responsibility for both domestic and international
96
Michael Mussa
financial policy in the U.S. administration. Paul Volcker was very well known
and highly regarded in the financial community and exceptionally well qualified to take command of the Federal Reserve at a time of economic turmoil
and crisis.
2.3.1 New Operating Procedures
The appropriate starting date for the assessment of U.S. monetary policy in
the 1980s is not the day of Paul Volcker’s accession to the chairmanship of the
Federal Reserve, however, but rather two months later, 6 October 1979. On
that Saturday, the Federal Reserve announced a new effort to discipline the
demon of rising inflation. The discount rate was raised a full percentage point
to a new record of 12 percent. New reserve requirements were imposed on
certain liabilities of member banks. Most important, the FOMC adopted new
operating procedures for the conduct of monetary policy.
Under the new operating procedures, the Open Market Desk would no
longer be directed to keep the Federal funds rate at a specified level or within
a narrow tolerance range but rather to supply a volume of bank reserves consistent with desired rates of growth of monetary aggregates prescribed by the
FOMC. Technically, the desk would operate by estimating the total volume of
bank reserves needed to support the short-term monetary growth targets set by
the FOMC. The amount of borrowed reserves likely to be supplied through
the Federal Reserve discount window would also be estimated. Through open
market operations, the desk manager would then supply the implied amount
of nonborrowed reserves appropriate to meet the target for total bank reserves.
It was recognized that, under these new operating procedures, the short-term
variability of the Federal funds rate was likely to increase substantially. A very
broad tolerance range would be specified for the Federal funds rate for the
periods between scheduled meetings of the FOMC. On 6 October the tolerance
range for the Federal funds rate was set at 11.5-15.5 percent. Since the Federal
funds rate had been running at about 11.5 percent during September, the new
broad tolerance range gave wide latitude to the manager of the Open Market
Desk to tighten reserve availability in order to reduce the growth rates of monetary aggregates as prescribed by the FOMC.
The shift to the new operating procedures was motivated by tactical, psychological, and political considerations and not by a profound religious experience
that suddenly converted most members of the FOMC to the doctrine of “monetarism.” Under the old operating procedures, the FOMC could have directed a
large increase in the Federal funds rate in order to restrain monetary growth
and resist rising inflation. Tactically, however, the FOMC did not know how
large an increase in the Federal funds rate might be needed, and it recognized
the virtue of significantly greater flexibility in adjusting the Federal funds rate
to deal with ongoing developments. Psychologically, in attacking inflationary
expectations, there appeared to be a gain from publicly announcing a more
“monetarist approach” to the general conduct of monetary policy rather than
97
Monetary Policy
just a change in the value of a particular policy instrument. Politically, the
new operating procedures offered an important degree of cover for the highly
unpopular action of sharply increasing interest rates and probably pushing the
economy into recession. The necessary rise in interest rates would not be so
visibly linked to Federal Reserve actions but could be blamed instead on market pressures arising from increased inffationary expectations and excess credit
demands from the government and the private sector. The Federal Reserve
could point to the generally agreed on need to resist inflation by restraining
monetary growth as the essence of its p01icy.~
2.3.2 The Initial Assault on Inflation
The financial market response to the new Federal Reserve policy was immediate and dramatic. On the following Monday, the short-term interest rates
leapt upward, and long-term bond prices tumbled. During the final two weeks
of October, the Federal funds rate rose to 15.5 percent, before falling back to
13.5 percent in November and then edging up to 14 percent in late December.
On average during the final quarter of 1979, short-term interest rates ran nearly
2 percentage points above late September levels, while long-term interest rates
rose about a percentage point above their late September levels. During the
final three months of 1979, growth of the monetary aggregates was slowed
very substantially from the rapid pace of the preceding six months; M1, M2,
and M3 recorded growth rates of 3,7, and 6.25 percent, respectively.
Economic data reported during the first three months of 1980 indicated relatively sluggish real growth during the final quarter of 1979 but an apparent
pickup of growth during January and February. Monetary growth remained
subdued in January. In February, however, growth of the newly defined, narrow
monetary aggregates, MIA and MlB, accelerated sufficiently to exceed the
(relatively stingy) short-run target rates set by the FOMC. In response to this
and other developments in the economy, the FOMC raised the upper limit of
the tolerance range of the Federal funds rate (in a series of telephone conferences and at the regular meeting on 22 March) from 15.5 percent to 20 percent.
The actual level of the funds rate jumped from 15 percent on 22 February to
19.4 percent by the end of March.
Despite the tightening of monetary policy, inflation continued to be very
rapid during the final quarter of 1979 and accelerated further during the first
quarter of 1980. Specifically, the (annualized) six-month inflation rate was recorded at 13.5, 13.3, and 13.4 percent in October, November, and December
of 1979 and then at 14.2, 14.9, and 15.9 percent in January, February and
March of 1980, respectively. Moreover, the remarkable surges in the prices of
gold (to over $800 per ounce), silver (to over $50.00 per ounce), and other
5. William Greider (1987) provides a detailed (if not always sympathetic) discussion of the
political and economic rationale underlying the shift in Federal Reserve operating procedures.
98
Michael Mussa
commodities by early February 1980 suggested growing hysteria about the
possibility of runaway inflation.
In this environment, on 14 March 1980 President Carter acted to combat
rising inflation. He announced a package of budget proposals to cut the projected federal deficit, and he authorized the imposition of controls on consumer
credit by the Federal Reserve. The objective of these actions was to reduce
pressures on interest rates arising from the federal deficit, to limit directly the
growth of consumer credit that appeared to be fueling the inflationary process,
and to attempt to break the psychological fear of uncontrolled inflation. As one
high official of the Carter administration once explained it, “We decided to
whack the donkey between the eyes with a two-by-four to make sure we had
its attention.”
2.3.3 Recession and Reversal
The budgetary proposals announced by President Carter were viewed with
some disdain in financial markets and probably had little effect on the economy. The response to the credit controls, combined with the Fed’s tight monetary policy, was virtually instantaneous-the economy nosedived into recession, with real GNP recording a spectacular 9 percent annualized rate of
decline. Short-term interest rates tumbled, with the three-month Treasury-bill
rate falling from 15.5 percent in March to 7 percent in June. The monthly
inflation rate fell off somewhat in April, May, and June from the very high
monthly rates in January, February, and March, but, on a six-month-average
basis, the inflation rate remained very high.
After declining slightly in March, the narrow monetary aggregates, M1A
and MlB, contracted sharply in April and then flattened out in May. The June
rebounds in these aggregates largely offset the April declines but still left both
M1A and M1B significantly below the lower limits of their longer-term target
ranges. The broader aggregate M2 declined only modestly in April, and the
strong rebound in June left it just above the lower limit of its target range. As
evidence became available of the shortfall of monetary growth below the shortterm targets set by the FOMC, and as other short-term interest rates dropped,
the Federal funds rate plummeted to the 13 percent lower limit of its tolerance
range by 6 May. The FOMC promptly reduced the lower limit of the tolerance
range to 10.5 percent, and the actual funds rate fell almost to this limit by
14 May.
At the regularly scheduled FOMC meeting on 22 May, the desk manager
was directed to provide reserves consistent with monetary growth rates “high
enough to promote achievement of the Committee’s objectives for monetary
growth over the year, provided that in the period before the next regular meeting the weekly average federal funds rate remains within a range of 8.5 to 14
percent.” Under this directive, the actual level of the Federal funds rate fell to
9.4 percent by the end of June. Thus, in three months, the Federal funds rate
had been cut by 10 percentage points from its peak in late March. By this
99
Monetary Policy
measure of monetary policy, all the tightening between the dollar stabilization
program announced on 1 November 1978 and the extraordinary measures of
March 1980 was effectively reversed.
Given the behavior of the monetary aggregates, the sharp decline of the Federal funds rate during the spring of 1980 was a natural consequence of the
monetary operating procedures of the Federal Reserve. However, the FOMC
knew that it had a choice about whether to permit a decline of quite such speed
and magnitude. It was not required by law or by deep religious conviction
to seek extremely rapid correction of all deviations of monetary growth from
previously specified targets. The manager of the Open Market Desk could have
been instructed to tolerate substantial shortfalls of MIA and MlB below their
previously announced target ranges. The FOMC could have retargeted monetary growth in the second half of 1980 at the previously announced rates, but
starting from the base established in the second quarter. This would have been
consistent with the “rebasing” of the growth targets in earlier years, when the
monetary aggregates had often grown near or even above the upper limits of
the preceding year’s growth targets.
The turmoil and uncertainty in the economy and financial markets provided
good reason for the Federal Reserve to be cautious in its conduct of monetary
policy. The virtually complete lack of experience with the Federal Reserve’s
new operating procedures provided additional reason for caution. Such caution
clearly did not justify an incredible, 10 percentage point drop in the Federal
funds rate in an effort to offset one or two months of negative growth of monetary aggregates. There was no precedent for such action. Only two or three
months into a recession that was widely regarded as the necessary consequence
of successful efforts to curb inflation, there was no credible reason to believe
that quite such a large and rapid drop in the Federal funds rate was necessary
to forestall a repeat of the Great Depression. Moreover, as illustrated in figure
2.4, the Federal funds rate fell much more sharply than any reasonable estimate
of what was happening to the rate of inflation. This alone should have raised
the caution sign that the Federal Reserve was being too aggressive in allowing
such a large and rapid decline in the Federal funds rate.
As suggested at the time by Governor Wallich, the Federal Reserve could
have resisted declines in the Federal funds rate below 12 or 13 percent while
awaiting more information about economic developments. This would still
have meant a very dramatic 6 or 7 percentage point easing of the cost of
Federal Reserve credit in response to the downturn in the economy and
in the monetary aggregates. Moreover, the record of the 22 April FOMC meeting reports that the committee was clearly apprised of the dangers that
“aggressive efforts to promote monetary growth might have to be reversed
before long, perhaps leading to significant increases in interest rates,” and
that “vigorous efforts in the short run to bring monetary growth into line with
the Committee’s longer-run objectives could result in excessive creation of
money.”
100
Michael Mussa
2.3.4 Rebound and Resurgence
Judged by the behavior of monetary aggregates, during the summer and
early fall of 1980 monetary policy was very expansionary. From well below
the lower limits of their target ranges in May, the narrow monetary aggregates
M1A and M1B shot upward during the next five months, with M1A rising to
near the upper limit of its range, and M1B rising above the upper limit of its
range in October. (For the path of MlB, which was subsequently redefined,
and M1, see fig. 2.2 above.) Meanwhile, M2 (as illustrated in fig. 2.3 above)
rose from slightly below the lower limit of its target range to moderately above
the upper limit. The Federal Reserve did not forcefully resist these monetary
developments by rapidly reversing the spring decline in the Federal funds rate.
The funds rate fell briefly below 9 percent in July and early August, generally
remained below 11 percent through mid-September, and was pushed as high
as 13 percent in the week before the 4 November presidential election.
Of course, in normal times, a 4 percentage point increase in the Federal
funds rate in four months would represent a dramatic tightening of monetary
policy. However, nothing about economic events in 1980 was very normal, and
the Federal Reserve had no rational basis for believing that its actions to raise
the Federal funds rate during the summer and early autumn of 1980 were in
any way symmetrical with its actions to cut the Federal funds rate during the
spring. In the spring, recognizing that a recession would probably be the necessary consequence of successful efforts to reduce inflation,two months of shortfall of the monetary aggregates below their target ranges had justified a 10
percentage point decline in the Federal funds rate. In the summer and early
fall, with no firm reason to believe that substantial permanent progress had
been made in reducing the inflation rate below about the 10 percent level, five
months of very rapid growth of the monetary aggregates led to only a 4 percentage point increase in the Federal funds rate. Moreover, as illustrated in
figure 2.5, not only did the interest rate of three-month Treasury bills fall significantly less than the Federal funds rate from late April to mid-June, but the
Treasury-bill rate also began to move upward fairly sharply two months before
the Federal Reserve began to push the Federal funds rate upward.
The recession of 1980 was sharp but very brief. By the summer of 1980,
economic activity began to recover. Retail sales began to rise in June after four
months of decline. Industrial production began to rise in August, having fallen
8.5 percent during the preceding six months. Employment, measured by the
household survey,began to recover in July, while nonfarm payroll employment,
measured by the establishment survey, began rising in August. Private housing
starts began recovering strongly in June. After falling sharply in the second
quarter, real GNP posted a slight gain during the summer. It then rose at a
vigorous 5 percent annual rate in the autumn and at a very rapid 9 percent
annual rate during the first quarter of 1981.
For one month, in July 1980, the CPI was nearly unchanged. The monthly
Monetary Policy
101
--I
20
Federal Funds Rate
15 -
I
mc
0
a“
10-
5-
O
L
- 5 ’
1975
-
1
I
I
1
1976
1977
1978
1979
1980
c
’
’
a
I
1
1981
1982
1983
1984
1985
1986
I
1987
I
1988
1989
199C
Fig. 2.5 Interest rates
Note: Federal funds rate and three-month Treasury-billrate, January 1975-April 1990.
inflation rate, however, picked up to 8 percent in August and 12 percent in
September. Even with the benefit of the July CPI result, the inflation rate for
the last six months of 1980 was 9.7 percent. The December-to-December
change in the CPI for 1980 was 12.4 percent, down only marginally from the
13.3 percent gain recorded for 1979. As measured by the GNP fixed-weight
price index, there was no decline of inflation during the second half of 1980,
and the inflation rate during all of 1980 was a percentage point higher than
during 1979.
2.3.5
An Abortive Victory
In retrospect, especially knowing the price yet to be paid during the recession of 1981-82 to refight the battle against inflation, it is clear that the Federal
Reserve accomplished only an abortive victory. Reducing inflation was the
clearly stated, number one priority of monetary policy for 1980. The Federal
Reserve clearly recognized that pursuit of this priority implied substantial
short-term risks for business activity. It specifically pointed to the midpoints
of its target ranges for monetary growth during 1980 as implying significant
constraint on inflation. Early in the year, the Federal Reserve took decisive
action to crush the bubble of inflationary hysteria. However, when the economy and the monetary aggregates turned sharply but briefly downward in the
spring, and as the first glimmer of hope appeared in the long-proclaimed effort
to reduce inflation, the Federal Reserve quickly and massively reversed the
thrust of its policy. As year’s end approached, the monetary aggregates were
not at the midpoints of their target ranges but rather near or above the upper
limits. Despite the pledges of forceful and persistent action to reduce inflation,
and despite the recession of 1980, “inflation did not abate in 1980,” as the
102
Michael Mussa
Federal Reserve conceded in its “Monetary Policy Report to Congress” in February 1981.
Of course, monetary policy is not made in retrospect. It is made in real time,
without prescient knowledge of the future, and often without very accurate
knowledge of what is currently happening. In this regard, 1980 certainly did
not provide a congenial environment for the conduct of monetary policy. The
economy shifted with unprecedented rapidity from inflation hysteria, to steep
recession, and then back to expansion and accelerating inflation. There was
little basis for assessing the impact on the economy of the imposition and subsequent removal of credit controls. Interest rates, usually a key indicator and
instrument for the conduct of monetary policy, moved around with incredible
volatility. The behavior of monetary aggregates was also extremely difficult to
interpret and predict in the face of wide swings in interest rates and the deregulation of depository institutions.
Moreover, the Federal Reserve’s new operating procedures seriously complicated the conduct of monetary policy during 1980. Partly, the problem was
that neither the Federal Reserve nor the banking and financial system had any
significant experience with the new operating procedures and certainly no experience relevant to the turbulent conditions of 1980. More important, many
members of the FOMC apparently felt that if was important to demonstrate
the seriousness and the symmetry of their commitment to the new operating
procedures. The procedures served to justify the aggressive tightening of monetary policy in the autumn of 1979 and the extraordinary efforts to combat the
inflationary hysteria of early 1980. When the economy tumbled into recession
in the spring and the monetary aggregates fell well below their target ranges,
symmetrical application of the new operating procedures demanded a very aggressive easing of monetary policy as measured by the Federal funds rate. Indeed, judged by the standard of achieving the monetary growth targets, the
Federal Reserve failed to cut the funds sufficiently in the spring of 1980.
During 1980, the conduct of monetary policy was further complicated by
the political environment of a presidential election. In the autumn of 1979 and
the winter of 1980, despite the likely political costs of a recession, the Carter
administration supported, or at least acquiesced in, the Federal Reserve’s tight
policy to combat rising inflation. When the economy fell steeply into recession, the administration approved the Federal Reserve’s easing of monetary
policy and surely would have been highly critical of the continuation of a very
tight policy. It is unclear, however, that the administration actively sought quite
the speed and extent of reductions in the Federal funds rate that occurred between late March and early June or that the administration could have effectively pressured a reluctant Federal Reserve to ease so dramatically.
During the summer and early autumn, as election day approached, administration officials understandably became increasingly unsympathetic toward
any tightening of monetary policy. Nevertheless, the Federal Reserve began to
nudge the Federal funds rate upward in September, and, on 25 September, the
103
Monetary Policy
Board of Governors authorized a full 1 percentage point increase in the discount rate-an unprecedented action so close to an election and one that elicited public criticism from President Carter. Despite this criticism, the Federal
Reserve allowed or induced about a further 2 percentage point increase in the
Federal funds rate before election day.
Market interest rates, however, began to move upward ten weeks in advance
of upward movements in the Federal funds rate. In particular, the short-term
Treasury-bill rate bottomed out by mid-June and had risen about 2 percentage
points by mid-August-a fact that was known contemporaneouslyat the Federal Reserve. Also, an explosion of monetary growth began in June and continued through the summer and early autumn-developments that were known
with only a brief delay at the Federal Reserve. Unquestionably, the Federal
Reserve postponed actions to tighten monetary policy that were clearly called
for by these developments under its own operating procedures. In all probability, political concerns about the consequences of a dramatic tightening of monetary policy shortly before a presidential election were an important reason for
this delay.
It should be emphasized that the political concerns that influenced the Federal Reserve during the summer and early autumn of 1980 were not narrowly
partisan-to aid in the reelection of President Carter. William Greider, who is
not a great admirer of the Federal Reserve, makes this point in Secrets of the
Temple (1987). He quotes Frederick Schultz, then vice chairman of the Federal
Reserve Board, as expressing the views of many members of the FOMC: “Our
attitude toward the election is that we’d like to dig a foxhole and crawl in until
it’s over.” Greider’s own conclusion is stated as follows:
This disposition [to avoid political involvement] undoubtedly inhibited policy makers from executing sharp, stringent policy moves in the middle of a
campaign if such decisions could be postponed. The majority of the FOMC,
for instance, might have been more open to the arguments for tightening in
the summer of 1980 if it had not been the season for presidential politics.
Some governors, if pressed, would concede that during a campaign they
would rather be easing than tightening if conditions permitted them to do
so. Most of all, they wished for a smooth policy line that would avoid aggravating either political party. (p. 214)
These political difficulties, together with the other substantial problems of
conducting monetary policy in the extraordinarily turbulent and uncertain environment of 1980, explain much of the erratic, seesaw course of monetary
policy. They do not, however, entirely excuse the Federal Reserve’s lack of
persistence and determination in confronting the demon of inflation. To an
important extent, the demon itself was the offspring both of the repeated failures to pursue sufficiently aggressive anti-inflation policies during the late
1970s and of the Federal Reserve’s generally poor record of combating inflation since the mid-1960s. During the spring of 1980, the Federal Reserve was
not compelled to ease as much as it chose to when the economy fell into
104
Michael Mussa
recession. As the record of its own meetings indicates, the FOMC was warned
about the possible need to reverse that policy if the recession proved short and
inflation resurged. It could and should have recognized the difficulties that
would be faced if such a reversal became necessary in the midst of the presidential election campaign.
Given the information available at the time, the Federal Reserve did not have
a particularly sound basis for engineering the entire precipitous drop of the
Federal funds rate during the spring of 1980, other than the desire to adhere to
its own new and untested operating procedures. If the Federal Reserve sought
to adhere to these operating procedures, it should and could have acted more
quickly and aggressively to restrain the resurgence of rapid monetary growth
during the summer and early autumn of 1980. The dismal record of the Federal
Reserve in nurturing and tolerating the rise of inflation during the preceding
three years justified and necessitated sustained action to combat inflation. In
1980, having summoned the courage to stand eyeball to eyeball with the demon
of inflation, the Federal Reserve should not have blinked.
2.4
Bloodshed and Victory
The second and ultimately successful effort to combat inflation during the
1980s really began, appropriately enough, on 4 November 1980-two years
after the dollar stabilization crisis of 1978 and on the day that Ronald Wilson
Reagan was elected president of the United States. For twenty-one months,
until August 1982, the Federal Reserve would consistently pursue a very tight
monetary policy. As a consequence of this effort, the inflation rate would be
driven down from 12.4 percent during 1980 to 3.9 percent during 1982. The
U.S. economy would also be pushed into a deep and prolonged recession during which real GNP would fall absolutely by 3.3 percent and the unemployment rate would rise to a postwar peak of 10.8 percent.
During the seven weeks following the presidential election, the Federal
funds rate was driven up 6 percentage points, to nearly 20 percent by midDecember 1980. The growth rates of the monetary aggregates fell off sharply
in November and December. By year’s end, the November-December slowdown in money growth pushed M1A back toward the midpoint of its target
range and drove M1B and M2 down toward the upper limits of their ranges.
Alternatively, adjusting for the larger than expected increase in NOW and ATS
deposits, it could be said that both M1A and M1B ended the year just below
the upper limits of their target ranges, after having shot from being well below
these ranges in late May to above their upper limits in October.
2.4.1 Twelve Months of Tight Money
The slowdown of monetary growth that began in November and December
1980 continued into January and February 1981, placing the narrow monetary
aggregates MIA and M1B (adjusted for shifts of deposits because of the na-
105
Monetary Policy
tionwide introduction of NOW accounts) well below their target ranges. During this brief period in early 1981, M 1A actually declined very sharply because
interest-bearing checking accounts (not included in MIA) became widely
available to individual households. In figure 2.6, which plots the six-month
annualized growth rates of M1A and MlB, this development is reflected in the
large negative growth rates of MIA during the first few months of 1981. For
MlB, the six-month annualized growth rate declines sharply in late 1980 and
early 1981 but does not become negative in early 1981. For M2, the six-month
annualized growth rate, illustrated in figure 2.7, declines substantially from its
relatively high level in the early autumn of 1980 but remains above the rate
implied by the midpoint of the FOMC’s target range for this aggregate.
As evidence of the substantial shortfall in the growth of the narrow monetary
aggregates became available in late January and February 1981, the Federal
funds rate fell from around 19 percent to the 15 percent lower limit of its
tolerance range. This development probably reflected market anticipations of
some easing by the Federal Reserve in pursuit of its monetary growth targets
more than it did deliberate actions by the manager of the Open Market Desk.
In any case, at its meeting on 2-3 February 1981, the FOMC decided that it
would accept for some time a shortfall of the narrow aggregates below their
short-term target ranges. Notably, at this juncture, the FOMC refused to authorize a further reduction in the lower tolerance limit for the funds rate.
At its meeting on the last day of March, the FOMC decided that, because of
the confusion associated with shifts of deposits between the narrow aggregates,
it would cease to make reference to M1A in its directive to the Open Market
Desk. At this meeting, it also adjusted the tolerance range for the Federal funds
rate to 13-18 percent. However, the funds rate fell below 15 percent only
briefly during April, before preliminary data began to show more rapid growth
of the monetary aggregates.
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
Year
Fig. 2.6 M1 money supply growth, January 1975-April 1990
Note: The money growth rate is a six-month moving average of the respective M1 growth rate.
106
Michael Mussa
-I
20
-
2
1975
0
1976
1977
~
1978
"
1979
"
1980
"
1981
"
1982
"
1983
~
1984
1985
~
1986
~
1987
~
1988
~
1989
~
1990
Year
Fig. 2.7 M 2 money supply growth, January 1975-April1990
Nore: The money growth rate is a six-month moving average of the M2 growth rate.
By early May 1981, monetary data showed MlB rising rapidly toward the
midpoint of its target range and M2 growing above the upper limit of its target
range. The Federal funds rate had already been pushed above the 18 percent
upper limit of its tolerance range. In a telephone conference on 6 May, the
FOMC authorized temporary excesses of the funds rate above this upper limit
in order that "the reserve path should continue to be set on the basis of the
short-run objectives for monetary growth." Two days earlier, the Board of Governors had raised the discount rate from 13 to 14 percent. At its regular meeting
on 18 May, the FOMC formally raised the tolerance range for the funds rate to
16-22 percent. When these actions were taken, it was clear that economic activity had expanded rapidly during the first quarter-the final confirming echo
of the rapid monetary growth of the summer and early autumn of 1980.
By the time of the FOMC meeting on 6-7 July 1981, it was apparent that
economic activity had leveled out in the second quarter, following a revised
estimate of a very strong growth during the first quarter. The large April increase in MlB had been reversed by sharp declines in May and June, and MlB
(adjusted for deposit shifts into NOW accounts) was again well below the
lower limit of its target range. M2 and M3 continued to grow above the upper
limits of their ranges. Federal funds had generally been trading in the range of
18.5-19.5 percent during the preceding six weeks. The FOMC lowered the
tolerance range for the funds rate to 15-21 percent in its directive of 7 July
and maintained this range until its meeting on 5-6 October, when the range
was reduced to 12-17 percent. Through mid-August, the actual level of the
funds rate declined only marginally to about 18 percent. It then moved erratically downward, generally remaining above 15 percent through the end of October. From July through October, M1B grew very slowly and fell further be-
107
Monetary Policy
low the lower limit of its target range, while M2 continued to skirt the upper
limit of its range.
In retrospect, it is clear that monetary policy was really very tight during the
twelve months from November 1980 through October 1981. For almost this
entire twelve months, the Federal funds rate was kept above 15 percent, half
the time in the range of 18-20 percent, On only two previous occasions had
the Federal funds rate ever reached or exceeded 15 percent: very briefly in late
October 1979 and for about two months from late February to late April 1980.
Moreover, measured in real terms, subtracting the six-month annualized rate
of change in the CPI, the Federal funds rate was exceptionally high from November 1980 through October 1981-generally in the range of 4-9 percent.6
The monetary aggregates also indicated a very tight policy. As illustrated in
figure 2.6 above, after spiking upward in late 1980, the six-month annualized
growth rate of MlB fell continuously during 1981 and reached almost zero in
October. MIA registered sharply negative growth for most of 1981. M2 grew
at an 8.7 percent annual rate between October 1980 and October 1981 but
failed to keep pace with the 10.2 percent rise in the consumer price index.’
After twelve months of very tight monetary policy, information received
during November and December 1981 indicated sharply declining economic
activity during the fourth quarter, after a small gain in the third quarter and a
small decline in the second. A recession was now clearly under way, and it was
expected to be at least as deep as the average recession since the Second World
War. Data on consumer and producer prices were generally showing inflation
rates much reduced from their levels earlier in 1981 and in 1980. Reflecting
both an actual and an expected slump in activity and decline of inflation, shortterm interest rates began to move sharply downward in very late September,
with yields on three-month Treasury bills registering more than a 4 percentage
6. There are several possible ways to measure the “real level of the Federal funds rate,” and they
yield somewhat different numerical answers. However, using any consistent method of measurement, this measure of monetary tightness was exceptionally high, relative to previous experience,
for a very long time during 1981, and it continued to be very high until the summer of 1982.
Subsequently during the 1980s, the real level of the Federal funds rate would generally remain
very high by the standards of the 1960s and 1970s. For the measure of the real level of the Federal
funds rate illustrated in fig. 2.4 above, this may be partly explained by the possibility that the
average anticipated rate of inflation during much of the 1980s ran somewhat above the six-month
annualized rate of change in the CPI and by the likelihood that the sharp declines in this measure
of inflation during late 1982 through early 1983 and again during 1986 did not correspond to
similar declines of the anticipated inflation rate. However, an important part of the continued high
real level of the Federal funds rate (and other interest rates) during the 1980s remains very difficult
to explain. It follows that this indicator of the stance of monetary policy needs to be interpreted
with care.
7. The real quantity of any monetary aggregate may be measured by dividing the nominal quantity by a measure of the price level. Using the CPI to measure the price level, between October
1980 and October 1981, the real quantity of M2 was falling. In the context of the behavior of all
the other indicators of monetary policy, this decline in the real quantity of M2 should be interpreted
as further evidence of a tight monetary policy.
108
Michael Mussa
point drop by year’s end. Long-term bond yields also dropped substantially
from their peaks in late September, with yields on Treasury bonds falling 1.5-2
percentage points by year’s end.
2.4.2
Nine More Months of Tight Money
The Federal Reserve responded to these developments by making monetary
policy only modestly less tight. The discount rate was cut from 14 to 13 percent
on 30 October and cut again to 12 percent on 3 December. The tolerance range
for the Federal funds rate was reduced to 11-1 5 percent at the FOMC meeting
on 21 November and then to 10-14 percent at the FOMC meeting a month
later. The actual level of the funds rate declined from 15 percent at the end of
October to 13.25 percent in mid-November and fell as low as 12 percent in
early December before turning upward. Growth rates of the monetary aggregates picked up somewhat in the final two months of 1981, with MlB rising
toward (but not quite to) the lower limit of its target range and M2 rising a
modest further amount above the upper limit of its range. The FOMC, however,
was not disposed to repeat the (never officially conceded) mistakes of 1979
and 1980 by directing a rapid acceleration of monetary growth at the first signs
of real weakness in the economy. The official record of the 17 November meeting of the FOMC notes (in the usual dry and understated tone of these documents):
Many members thought that an aggressive effort to stimulate MIB growth
over November and December at a pace sufficiently rapid to compensate for
the shortfall in October would interfere with achievement of longer-term
economic goals and would risk overly rapid expansion of money and credit
in later months, particularly if the effort were accompanied by a precipitous
decline in short-term interest rates to levels that might not be sustainable.
In 1982, the Federal Reserve stopped reporting and announcing growth targets for MIA and relabeled M1B more simply as M1.8 In January, M1 grew at
a very rapid 21 percent annual rate, after increasing at an 11 percent rate in
December 1981. This placed M1 significantly above the target range for that
aggregate established by the FOMC. M2 grew at a 13 percent rate in January
1982 (originally estimated as 11 percent), after rising at an 11 percent rate the
preceding December (originally estimated as 8 percent). These developments
placed M2 slightly above its target range by the time of the FOMC meeting on
1-2 February 1982.
It was known at the time that most of the large January gain in M1, as well
as much of the increase in this aggregate in November and December 1980,
came from other checkable deposits (OCD). OCD consists of interest-bearing
checkable deposits in NOW and ATS accounts at all depository institutions
8. The definitions of M2 and M3 were also modified. Money market funds held by institutions
were removed from M2 (and remained in M3), and retail repurchase agreements of less than
$1OO,OOO (already in M3) were added to M2.
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Monetary Policy
and small amounts of demand deposits at thrift institutions and credit unions.
OCD is the part of M1 (previously M1B) that is not in MIA, the old concept
of M1 consisting of currency plus non-interest-bearing demand deposits at
commercial banks. It is now known that OCD has a much lower transactions
velocity than ordinary demand deposits, indicating very strongly that the January 1982 increase in OCD and correspondinglyin M1 did not signal that monetary expansion was exceedingly rapid. Even at the time, there was good reason
to suspect that this was true and to pay heed to continuing signals from MIA
that monetary policy remained quite tight. The Federal Reserve, however, had
removed M1A from any direct role in the short-run operation of monetary
policy in March 1981 and was committed to abandoning this aggregate altogether in February 1982.
Knowing the Federal Reserve’s operating procedures, financial markets focused on the short-run behavior of M1 (= M1B) and M2, for which estimates
were announced weekly. If the Federal Reserve was believed to be serious
about achieving its monetary growth targets (as apparently it was in late 1981
and early 1982), then market forces would automatically tend to force the Federal funds rate and other short-term interest rates upward once it was reported
that growth of M1 (= M1B) was accelerating above its presumed target in late
December 1981 and January 1982. In any event, whether as an automatic result
of market forces or with some additional push from the Open Market Desk,
the Federal funds rate did rise from 12.25 percent around 20 December to 14
percent at the end of January.
At the FOMC meeting on 1-2 February 1982, it was recognized that the
January rise in M1 resulting from the rapid growth of OCD was probably a
deviation that should not be corrected by an effort to drive M1 rapidly back
toward its target range. On the other hand, the FOMC was not prepared to
ignore entirely the January increase in M1 or to alter its previously announced
target ranges, or to reintroduce M1A into the monetary control procedures.
Instead, to move M1 back toward its target range for 1982, the FOMC directed
that no further growth should occur in M1 in the period January-March, and
it raised the tolerance range for the Federal funds rate to 12-16 percent. It is
noteworthy that this decision was taken in the knowledge that M1 (= M1B)
had undershot its 1981 target range and that the rapid January growth had
placed this aggregate only slightly above the lower limit of the extension of
the 1981 target range. It was also taken in the knowledge that real GNP was
estimated to have fallen at a 5.25 percent annual rate in the final quarter of
1981, that preliminary indicators suggested a further decline in output during
the first quarter of 1982, and that inflation was continuing the clear trend of
moderation that had begun in 1981. Clearly, something had changed since the
spring of 1980 in the Federal Reserve’s approach to dealing with the risks of
recession and inflation.
On balance, M1 grew very little between January and the end of June. M2
grew sufficiently slowly to fall just below the 9 percent upper limit of its target
110
Michael Mussa
growth range in March and subsequentlyran essentially along this upper limit.
After January, the Federal funds fluctuated generally between 14 and 15.5 percent and ended June at about 14.5 percent. Since the inflation rate (measured
by the six-month annualized rate of change in the CPI) was running around
6 percent, the Federal funds rate in real terms generally exceeded 8 percent.
Economic data during this period indicated, on balance, little change in output
during the second quarter. Nonfarm payroll employment continued to decline,
however, and the unemployment rate rose from 8.6 percent in January (already
above the 7.8 percent peak reached during the brief 1980 recession) to 9.6
percent in June-at that point a record unemployment rate for the postwar era.
2.4.3
The Shift to Easier Money
By the end of June, the very slow growth of M1 for five months had erased
the January bulge and brought this aggregate near to the upper limit of its 1982
target range. M2 continued to grow along the upper limit of its range. At this
point, adherence to the monetary targets would have implied continuation of a
tight monetary policy to bring both M1 and M2 toward the midpoints of their
announced ranges. Some members of the FOMC (Governor Wallich and Reserve Bank Presidents Black and Ford) clearly favored this course. Alternatively, in view of the depressed level of business activity, the FOMC could
have explicitly raised the targets for monetary growth. Governor Teeters, long
a proponent of a somewhat less tight monetary policy, was an advocate of this
latter option. The FOMC pursued neither of these courses. It did, however,
raise the short-term growth targets for M1 and M2 by 2 and 1 percentage
points, respectively, and it instructed the manager of the Open Market Desk
that “somewhat more rapid growth would be acceptable.”
With this decision, the FOMC effectively began fundamental change in the
course of monetary policy in the direction of substantially greater ease. Initially, this change in policy was not apparent in the behavior of the monetary
aggregates, as M1 declined slightly in July, while M2 growth increased modestly. In the face of a still deepening recession, however, the Federal funds rate
dropped from 14.5 percent at the end of June to 15 percent by mid-July and to
11 percent by the end of July. The Federal Reserve Board cut the discount rate
half a percentage point, to 11.5 percent on 19 July, by another half percentage
point on 30 July, and by another half percentage point on 13 August. By late
July, financial markets began to take the hint. The yield on three-month Treasury bills fell more than 4 percentage points between late July and the end of
August, while longer-term bond yields declined more than 1.5 percentage
points. Stock prices began what was to become the great bull market of the
1980s with a strong rally in August. The Federal funds rate fell to 10 percent
by 18 August and to 9 percent just before the FOMC meeting on 24 August,
at which time the tolerance range was reduced to 7-1 1 percent.
Monetary growth picked up considerably in August, with M1 and M2 rising
at rates of 12 and 13 percent, respectively, and quite rapid monetary growth
111
Monetary Policy
generally continued to the end of 1982 and throughout 1983. The Federal
funds rate fell to 9 percent by the end of 1982 and generally ran in the range
of 8.5-9.5 percent during 1983. The discount rate was cut five more times
between 17 August and 17 December, down to a level of 8.5 percent, where it
was held throughout 1983.
Thus, the very tight monetary policy that the Federal Reserve embarked on
in November 1980 began to be reversed in July-August 1982-a year after the
officially recognized starting date of the 1981-82 recession. Economic activity
continued to decline until November 1982, with the unemployment rate rising
ultimately to a peak of 10.8 percent. The demon of inflation, however, had
finally been tamed. During the twelve months of 1982, the CPI rose only 3.8
percent, and the annual inflation rate would remain generally in the neighborhood of 4 percent through the rest of the decade.
2.4.4
The Rationale for Tight Money
In retrospect, it is clear that the prolonged tightening of monetary policy
from late 1980 to mid-1982 was the most important action taken by the Federal
Reserve during the 1980s and perhaps the most important monetary policy
action since the catastrophic failure of the Federal Reserve to resist the monetary collapse of the early 1930s. Four important points should be discussed
concerning the rationale for this policy.
First, an extended period of very tight money that would push the economy
into deep and prolonged recession was not exactly the publicly announced intention of the Federal Reserve. Federal Reserve officials, especially Chairman
Volcker, did indicate the need for a sustained and determined effort to combat
inflation, even at the expense of considerable pain to the economy. However,
in its semiannual “Monetary Reports to the Congress,” the Federal Reserve
usually suggested a more gradual approach to restoring stability to the general
level of prices-an approach that was officially endorsed by the Reagan administration. In this regard, a passage from the “Monetary Policy Report” of
25 February 1981 is noteworthy:
It is essential that monetary policy exert continuing resistance to inflationary
forces. The growth of money and credit will need to be slowed to a rate
consistent with the long-range growth of the nation’s capacity to produce at
reasonably stable prices. Realistically, given the structure of the economy,
with the rigidities of contractual relationships and the natural lags in the
adjustment process, that rate will have to be approached over a period of
years if severe contractionary pressures on output and employment are to
be avoided.
Second, while the Federal Reserve clearly did not pursue a policy that
avoided severe contractionary pressures on the economy, it is arguable that
no such policy would have achieved a substantial and sustained reduction of
inflation. To succeed in the effort to reduce inflation, millions of private actors
112
Michael Mussa
in the economy and in financial markets needed to be persuaded that inflation
in the future would proceed at a substantially lower rate than in the past. Persuasion would be very difficult because, consistently for five years before 1981
and generally for the preceding ten years, people who had acted on the assumption that future inflation would be low turned out to be the economic losers
whereas people who had acted on the assumption that future inflation would
be high had been the economic winners.
Thus, to succeed in reducing inflation, the Federal Reserve had to establish
its credibility as a consistent and effective warrior against the demon of inflation. Given the Federal Reserve’s dismal record in restraining inflation since
1976, including the retreat of 1980, there was only one effective way for the
Federal Reserve to demonstrate the anti-inflationary resolve of its monetary
policy. The Federal Reserve had to show that, when faced with the painful
choice between maintaining a tight monetary policy to fight inflation and easing monetary policy to combat recession, it would choose to fight inflation. In
other words, to establish its credibility, the Federal Reserve had to demonstrate
its willingness to spill blood, lots of blood, other people’s blood.
Third, the Federal Reserve’s tight monetary policy was partly the consequence of understandable and unavoidable miscalculation. The official record
of the deliberations of the FOMC indicates that the likely depth and duration
of the recession were consistently underestimated. To some extent, this tendency was probably a psychological correction for the FOMC’s earlier errors
in anticipating the 1979 recession that never quite materialized and in failing
to appreciate the rapidity of the turnaround from recession to expansion in the
summer of 1980. Outside the Federal Reserve, however, it was also widely
believed that the 1981-82 recession would end five or six months sooner than
it did-partly because of the expected expansionary effects of the Reagan administration’s fiscal policy.
Moreover, judging the tightness or ease of monetary policy in the turbulent
economic and financial conditions of 1981-82 was no easy task. There was
a sharp downward shift in the velocities of circulation of various monetary
aggregates that altered the significance of the growth rates of these aggregates
as indicators of monetary policy. The occurrence and implications of substantial downward shifts in velocities were known and appreciated at the Federal
Reserve. However, no one, including the Federal Reserve, had a firm basis
for assessing precisely how much velocity shifted for different aggregates. In
retrospect, knowing how much velocities did shift during 1981-82, the Federal
Reserve’s policy may now appear somewhat tighter than was reasonably understood or intended at the time. The Federal funds rate also became a less reliable
indicator of monetary policy as market interest rates fluctuated with unprecedented volatility and as the anticipated inflation rate shifted downward to an
extent that was extraordinarily difficult to evaluate. For understandable reasons, the Federal Reserve failed to appreciate how tight its policy really was,
113
Monetary Policy
in the context of a recession that turned out to be deeper and longer than originally anticipated.
Fourth, making due allowance for underestimates of the depth and duration
of the recession and for the difficultiesin assessing the actual tightness of monetary policy, it is nevertheless clear that the Federal Reserve knowingly persisted in a very tight monetary policy for many months after the economy had
fallen into rece~sion.~
Indeed, as early as July 1981, with a year of tight monetary policy still in store, the forecasts presented to the FOMC pointed to a
deep and prolonged recession even under the most expansionary options for
monetary policy.'O Having backed off from further monetary tightening during
much of 1979, and having reversed policy so rapidly and ignominiously in
1980, most members of the FOMC recognized that this time they had to hold
on to a tight policy until there was unmistakable evidence of real progress in
reducing inflation. The financial markets particularly, and the economy more
generally, were so sensitized by previous failures to control inflation that the
Federal Reserve perceived little latitude to ease monetary policy before the
summer of 1982.
2.4.5
An Excessively Tight Policy?
All things considered, it is still arguable that the Federal Reserve may have
kept monetary policy too tight for too long during 1982. Taking account of the
relatively high unemployment rate when the recession started and of the time
before recovery restored the economy to near its longer-term growth path, the
loss of output during the 1981-82 recession probably amounted to $200-$300
billion (in 1982 dollars), or possibly more." As tends to be the case with long
and deep recessions, many workers and businesses never recovered an important part of the ground lost during this downturn. Other longer-term problems of the recession and the period of very high interest rates-notably the
9. The disparity between the Federal Reserve's rhetoric suggesting a gradualist approach to
combating inflation (discussed above) and its actual policy is not indicative of an effort to deceive
the public or the Congress. People well understood that the Federal Reserve's policy was very
tight, and it served the Federal Reserve's objectives to sustain this understanding. It was not polite
or politically astute, however, to be too explicit about the casualties that might result from the
Federal Reserve's policy or to contradict directly the administration's announced preference for a
gradualist approach.
10. At each meeting of the FOMC, analyses of the performance and prospects for the economy
are presented in the Greenbook and the Bluebook. The forecast presented to the FOMC at its
July 1981 meeting is discussed explicitly in Karamousis and Lombra (1989). The most optimistic
scenario presented for consideration by the FOMC envisioned an 8.3 percent average unemployment rate for 1982 and an 8.8 percent average unemploymentrate for 1983.
11. The Hodrick-Prescott filter used to construct the smoothed trend path for real GNP in fig.
2.1 above indicates that real GNF' barely fell below this trend during the recession of 1980 and
was significantly above this trend in mid-1981. Using deviations from the Hodrick-Prescott trend
to measure the output loss from the 1981-82 recession results in a comparatively small measured
loss-about $200 billion. If the loss is measured relative to a trend passing through the actual level
of real GNP during the second quarter of 1981,the loss is significantlylarger-about $300 billion.
114
Michael Mussa
continuing problems of the savings and loan industry-are still of pressing
importance in the United States. Other countries, particularly in Latin
America, also felt and are still feeling the consequences of high interest rates
and recession in the United States during the early 1980s. Moreover, given the
fragile state of the U.S. financial system by the summer of 1982, avoidance of
an even more serious economic downturn should be regarded as a fortunate
outcome.
Of course, only a modest fraction of the cost of the recession of 1981-82
(and of associated economic problems) can be attributed to excessive and inappropriate tightness of monetary policy. Most of the cost is properly attributed
to the necessity of combating the virulent inflation that was, in substantial measure, the consequence of previous laxity of monetary policy. Also, other factors
such as the second oil price shock probably contributed in important ways to
the length and depth of the recession. Nevertheless, if a somewhat less tight
monetary policy during 1982 would have shortened the recession by even three
or four months, without sacrificing a great deal of the progress in reducing
inflation, it would have been a more desirable policy.
The difficulty is knowing at what point the Federal Reserve could have
moved to a somewhat easier policy without provoking an adverse reaction by
raising fears of future inflation. This problem clearly influenced the policy
followed by the Federal Reserve, as expressed in the Federal Reserve’s “Monetary Policy Report to the Congress” of 20 July 1982:
Unfortunately, these stresses [of the recession] cannot be easily remedied
through accelerated money growth. The immediate effect of encouraging
faster growth in money might be lower interest rates, especially in shortterm markets. In time, however, the attempt to drive interest rates lower
through a substantial reacceleration of money growth would founder, for the
result would be to embed inflation and expectations of inflation even more
deeply into the nation’s economic system. It would mean that this recession
was another wasted painful episode instead of a transition to a sustained
improvement in the economic environment.
Ironically, this statement is phrased as an expression of the Federal Reserve’s
future intentions rather than as a justification of its past actions. On the very
day that this statement was released, the Federal Reserve cut the discount rate
from 12 to 11.5percent, signaling the beginning of what would become a fourand-a-half-yearperiod of quite rapid monetary expansion. During this period,
interest rates, both short and long term, would be driven significantly lower,
and the U.S. economy would substantiallyrecover from the devastation of both
inflation and recession. By July 1982, enough blood had been spilled that the
credibility of the Federal Reserve’s anti-inflationary policy was established.
Now, the economy generally, and the financial markets particularly, would sigh
in relief or cheer in ecstasy, rather than shriek in terror, at the fact and prospect
of a substantially easier monetary policy.
115
Monetary Policy
2.5 Savoring the Fruits of Victory
The victory over inflation and the obviously distressed state of the American
economy were the key considerations leading to the Federal Reserve’s shift to
an easier monetary policy. Insofar as political considerations influenced the
Federal Reserve’s decision, these considerations all weighed in favor of the
new policy. Concerned about the prolonged and deepening recession, many
officials of the Reagan administrationhad been arguing for some time in favor
of an easier monetary policy. On Capitol Hill, despite the upcoming congressional elections, monetary policy was not an issue of partisan dispute. Prominent legislators from both parties had been pressing for an easier policy since
late 1981. Indeed, some Democrats were pushing legislation that would have
limited the independence of the Federal Reserve and required the pursuit of an
easier, lower-interest-ratemonetary policy.’*
As previously discussed, the Federal Reserve responded to criticism of its
tight monetary policy by pointing to the necessity of maintaining a firm stance
against the resurgence of inflation. In addition, Chairman Volcker and other
members of the FOMC argued that the large and growing federal deficit was
an important cause of high interest rates and that serious efforts to cut the
deficit were essential to reduce interest rates without reigniting inflation. The
evidence supporting this view was, and remains, somewhat ambiguous. Nevertheless, there is no doubt that the Federal Reserve’s concern over the effect of
the deficit on interest rates was genuine and that this concern was widely
shared outside the Federal Reserve, especially in the financial community. The
Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982, which sought to
reduce the federal deficit by partially reversing the tax cuts of 1981, was passed
by Congress in mid-August. There is no clear evidence, however, that the passage of TEFRA was instrumental in persuading the Federal Reserve to ease
monetary policy or that it played a particularly important role in the subsequent
decline of interest rates.
2.5.1 Problems in the Financial System
In addition to concerns about the general health of the economy, it does
appear that the Federal Reserve’s shift to an easier monetary policy was influenced by specific concerns about the stability of the banking and financial system. In late June 1982, Federal Reserve officials learned that the Penn Square
National Bank of Oklahoma City was on the verge of failure. The failure of
Penn Square, with its prospective losses to depositors, was publicly announced
on 5 July. It sent tremors through the banking system-tremors to which the
Federal Reserve was very sensitive-as other banks and their uninsured depositors and other uninsured creditors womed who might be next.
12. As on other issues concerning political influences on the Federal Reserve, an excellent discussion of the events of 1981-82 is provided in Greider (1987).
116
Michael Mussa
Of even greater importance, Federal Reserve officials were aware at least as
early as June 1982 that the government of Mexico was experiencing considerable difficulties in arranging new financing for a large volume of commercial
bank loans coming due during the summer. Many of the largest banks in the
country were important creditors of the Mexican government, and Mexico was
not the only country with large loans from U.S. banks that was in obvious
economic difficulty. Default by the Mexican government would be a financial
bombshell that could easily provoke a nationwide banking and financial crisis.
On the thirteenth of August-appropriately a Friday-the Mexican finance
minister Jesus Silva Herzog arrived at the U.S. Treasury and at the Federal
Reserve with the sad news that the Mexican government’s coffers were empty
and that default would occur the following week. A large bailout package was
arranged over the weekend, and default was avoided. However, the message
remained clear-the banking system was in seriousjeopardy unless something
substantial was done soon to stimulate economic recovery.
2.5.2
Full Speed Ahead
As previously discussed, the Federal Reserve began to ease monetary policy
in July 1982 and pushed hard in the direction of easing from August through
December 1982. With the shift to a much easier monetary policy, M2 and M3
rose from somewhat below to somewhat above the upper limits of their target
ranges. M1 began to grow at about twice the maximum targeted rate and rose
well above the upper limit of its target range by year’s end. Since interest rates
fell dramatically during this period, and since M2 and M3 contain more interest sensitive elements than M1, the relative behavior of these aggregates was
not surprising. Nevertheless, during the fall of 1982, the behavior of M1 was
becoming an embarrassment to the Federal Reserve; it was indicating far too
clearly that the Federal Reserve had given up on the monetary targets announced in February (and reaffirmed in July) in order to pursue a much easier policy.
At the FOMC meeting on 5 October 1982, this problem was solved by deciding that, “because the behavior of M1 over the balance of the year is subject
to unusually great uncertainties,” a short-term target for growth of M1 would
no longer be used as an operational guide for the execution of monetary policy.
Instead, a short-term growth target for M2 (and M3) in the range of around
8.5-9.5 percent at an annual rate from September to December was the officially stated guide for the manager of the Open Market Desk. The expiration of
all savers certificates in October and the introduction of money market demand
accounts (MMDAs) in December were discussed as reasons for especially
great uncertainty about the behavior of M1. It is noteworthy, however, that,
when MI grew unusually rapidly during January 1982 because of growth in
its OCD component, the FOMC did not choose to ignore MI. At that time, the
FOMC wanted to continue a quite tight monetary policy, and the behavior
of M1 provided a plausible rationale for continuing such a policy. In Octo-
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Monetary Policy
ber, when the behavior of M1 was becoming an impediment to the FOMC’s
desire to ease monetary policy, M1 got dumped as an effective monetary
target.
During the autumn of 1982, not only was M1 dumped as a target for monetary policy, but the whole procedure of using monetary growth targets as the
operational guide for monetary policy instituted in October 1979 was effectively abandoned. The Federal Reserve returned to operating procedures similar to those employed in the 1950s and 1960s,when monetary policy indirectly
targeted the level of the Federal funds rate. Under the procedures used from
October 1982 until the late 1980s, the FOMC determined the “degree of restraint” or “degree of pressure” to apply to the reserve position of banks, as
calibrated by the extent to which banks needed to come to the Federal Reserve’s discount window to borrow reserves.
Given the level of the discount rate and the policies of the Federal Reserve
that control borrowing at the discount window, there is a relatively precise
relation between the amount of borrowing and the level of the Federal funds
rate. In the official language of the directive, “maintaining the existing degree
of restraint (or pressure) on bank reserves” means holding the Federal funds
rate constant, “increasing the degree of pressure” means raising the Federal
funds rate, and “reducing the degree of pressure” means reducing the Federal
funds rate. However, since the relation between the “pressure on reserves” and
the Federal funds rate is not exact and constant, there is more room for the
funds rate to move around under indirect targeting than was the case under the
direct targeting procedures used in the late 1970s. (Recently, since 1987,
the operating procedures appear to have moved back toward direct targeting of
the funds rate, but there has been no official announcement of such a change.)
During 1983, the FOMC observed what was going on in the economy: a
vigorous recovery of business activity with no sign of increasing inflation.
With good reason, it liked what it saw. When the year was over, real GNP had
risen by 6.5 percent (fourth quarter to fourth quarter), the unemployment rate
had fallen 2.5 percentage points, and the twelve-month gain in the CPI was
only 3.8 percent. On fifteen occasions, the Board of Governors turned down
requests from Reserve banks for changes in the discount rate and held the
discount rate constant at 8.5 percent. Throughout the year, the FOMC directed
only slight changes in the degree of restraint on bank reserves, and the Federal
funds rate moved narrowly (by the standards of recently preceding years)
within the range of 8.5-9.5 percent.
The behavior of the monetary aggregates was monitored and discussed by
the FOMC during 1983, but that behavior exerted little apparent influence on
decisions concerning the degree of pressure on bank reserves. The deemphasis
of the M2 growth target early in the year was officially rationalized by the
instabilities created by the introduction of MMDAs. Rapid growth of MMDAs
accounted for much of the very rapid growth of M2 during the first quarter of
1983.Following its decision of October 1982,the FOMC also ignored the very
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Michael Mussa
rapid growth of M1 throughout 1983, and it only “monitored” the behavior of
this aggregate.
2.5.3 An Interval of Tightening
In January and February 1984, the Federal Reserve maintained the same
policy stance that it had adopted in 1983. The degree of pressure on bank
reserves kept the Federal funds rate close to 9.5 percent. In a telephone conference on 20 March 1984, the FOMC discussed recent increases in market interest rates and noted that “economic activity in most sectors was rising with
considerable momentum, helping to generate strong demands for credit.” The
committee decided to relax informally the 10 percent upper limit of the tolerance range for the Federal funds rate. Subsequently, the tolerance range for the
Federal funds rate was raised to 7.5-1 1.5 percent (at the FOMC meeting on
26-27 March) and to 8-12 percent (at the FOMC meeting on 16-17 July). The
discount rate was raised from 8.5 to 9 percent on 6 April. The actual level of
the funds rate was kept between 10 and 10.5 percent through June, then raised
gradually to slightly over 11.5 percent in August, and then eased down to
around 11 percent in late September.
The primary reason for the brief tightening of monetary policy from late
March through September 1984 was the worry that continued rapid economic
expansion was raising the risks of an acceleration of inflation. Estimates of real
GNP growth indicated about a 9 percent real growth rate during the first quarter of 1984 and a still very rapid 7.5 percent rate of advance during the second
quarter. When it became clear that the pace of expansion slowed considerably
during the summer of 1984 and continued to be relatively sluggish during the
fourth quarter, the Federal Reserve moved aggressively (but with some dissent
within the FOMC) to reverse the monetary tightening of the period MarchSeptember. In October, the Federal funds rate was pushed down to 10 percent.
In November, and again in December, the FOMC gave explicit directives to
ease pressures on bank reserves, and the tolerance range for the Federal funds
rate was reduced to 6-10 percent. The discount rate was cut to 8.5 percent on
21 November and then to 8 percent on 21 December. By year’s end, the Federal
funds rate had been pushed slightly below 8.5 percent.
In the official record of the FOMC’s discussions of monetary policy during
1984, considerable attention is devoted to the behavior of monetary aggregates,
with M1 being resurrected to a status of some importance. After a year and a
half of rapid monetary growth and a full year of economic recovery, the Federal
Reserve wished to maintain the hard-won credibility of its anti-inflation policy
by indicating a more serious commitment to its monetary growth targets. When
problems arose at the Continental Illinois National Bank during the spring
and summer, the Federal Reserve sought to persuade financial markets that
aid to Continental would not push the aggregates off target. Indeed, figures
2.2 and 2.3 above and figures 2.8 and 2.9 reveal that 1984 is the only year
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Monetary Policy
<YY
800 -
700
-
600 -
3-
-B
500-
-
:,
m
400
-
Fig. 2.8 M1 and growth target ranges, January 198&April1990
Note: The monetary targets are those established by the FOMC at the beginning of each year for
annual growth rates.
in the entire history of monetary targeting by the Federal Reserve when
both M1 and M2 ended the year near the midpoints of their respective target
ranges.
During most of the 1980s, efforts to achieve the monetary growth targets,
especially for M2, had some impact on the conduct of monetary policy. In fact,
except for the aberration rationalized by introduction of MMDAs in early
1983, M2 ended each year of the 1980s within or very close to its announced
target range. However, the target range was relatively broad, and the record
indicates that achieving growth near to the midpoint of the range did not outweigh the actual and prospective performance of the economy as a dominant
determinant of Federal Reserve policy.
Of course, 1984 was a presidential election year. Some in the administration
were not particularly happy that the Federal Reserve embarked on a monetary
tightening seven months before the election. Their concerns were more than
narrowly political. Many monetarists believed that sharp changes in rates of
growth of monetary aggregates were an important cause of economic instability. While they worried that the rapid money growth from October 1982
through 1983 might stimulate increased inflation, they also feared that too
sharp a monetary slowdown might abort the economic recovery. Such concerns
about changes in the rates of growth of monetary aggregates, however, were a
bit too esoteric for most of the financial community and the press. By pursuing
its announced monetary targets, the Federal Reserve probably helped insulate
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Michael Mussa
1.000
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
Year
Fig. 2.9 M2 and growth target ranges, January 1980-April 1990
Note: The monetary targets are those established by the FOMC at the beginning of each year for
annual growth rates.
itself from monetarist criticism. Thus, there was a marriage of convenience
between the monetary tightening that the FOMC believed to be economically
appropriate and the conscientious pursuit of its monetary growth targets.
In the latter part of 1984, an additional concern began to influence Federal
Reserve policy: the extraordinary appreciation of the U.S. dollar against foreign currencies and the actual and prospective deterioration in the U.S. trade
and current account balances. The dollar appreciated consistently, with only
occasional small reversals, from the summer of 1980 until it reached its peak
in early 1985. By late 1983, on a trade-weighted basis, adjusted for relative
movements in national price levels, the real foreign exchange value of the dollar against other major currencies had risen about 45 percent from its low in
the summer of 1980. At the Federal Reserve, and in the administration, most
of this appreciation was regarded as a favorable development since a strong
dollar helped reduce inflationary pressures. By the summer of 1984, the dollar
had appreciated about another 10 percent in real terms, and it continued to
appreciate in the autumn (rising a further 10 percent by the time of the peak in
early 1985). At this point, the exceptionally strong dollar became a major concern in discussions about monetary policy, as indicated in the official record of
the FOMC meeting on 21 December 1984:
As they had at previous meetings, the members gave a good deal of attention
to the effects of the continued strength of the dollar in foreign exchange
markets. The related surge in imports was having a very negative impact on
production in many domestic industries, while expansion of exports was be-
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Monetary Policy
ing curbed by the appreciated value of the dollar as well as by relatively
slow economic growth abroad.
The directive from this FOMC meeting specifically refers to “the continued
strength of the dollar in foreign exchange markets” as a factor that should lead
to further easing of monetary policy.
2.5.4
A Return to Easy Money
During 1985 and 1986, conditions in the economy, rather than the behavior
of the monetary aggregates, continued to dominate Federal Reserve actions
concerning the Federal funds rate and the discount rate. On balance, monetary
policy was quite expansionary, in an environment of subdued inflation and
moderate economic growth.
Specifically, in early 1985, concerns about the strong dollar and evidence
that suggested a significant weakening of economic expansion (following a
modest pickup in the fourth quarter of 1984) counterbalanced concerns about
rapid expansion of the monetary aggregates. The Federal funds rate was kept
in a relatively narrow range near 8.5 percent through the first four months of
the year. As available evidence continued to indicate a very weak first quarter
and a quite sluggish second quarter, the Federal funds rate was reduced to 8
percent in May and fell briefly to near 7 percent during June before returning
to about 8 percent at the end of the month. The discount rate was cut from 8
to 7.5 percent on 17 May.
Nothing in the behavior of the monetary aggregates plausibly rationalized
these adjustments. During the first half of 1985, M1 grew significantly above
the upper limit of its target range, while M2 grew above and then along the
upper limit of its target range. Moreover, revised data would ultimately show
(years later) that economic growth had been considerably more vigorous during the first half of 1985, especially during the first quarter, than was believed
at the time.
During the second half of 1985, the contemporaneously available evidence
generally pointed to a moderate pace of economic expansion after a very slow
first half. There were, however, mixed signals from different economic indicators, and there was some division among members of the FOMC concerning
the prospects for future growth. Indicators of inflation generally showed the
lowest rates of the 1980s, until modest upturns were reported in November and
December. Despite persistent rapid growth of M1 above its target range and
growth of M2 along the upper limit of its range, the FOMC decided not to
increase the pressure on bank reserve positions from July through December
and made one decision to ease slightly at its meeting in November. The Federal
funds rate was maintained near 8 percent from July until December, when it
rose briefly and marginally to about 8.25 percent.
International concern about the strong foreign exchange value of the dollar
and its effects on payments imbalances and protectionist pressures led to the
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Michael Mussa
Plaza Agreement of 22 September 1985. In this agreement, the finance ministers and central bank governors of the G-5 countries (France, Japan, the United
Kingdom, the United States, and West Germany) announced their intention of
seeking a somewhat lower foreign exchange value of the U.S. dollar and of
pursuing other measures to reduce payments imbalances.
The Plaza Agreement, however, had little direct effect on U.S. monetary
policy. In the months before the agreement, the FOMC had been concerned
with the strong dollar, and this concern was one factor that probably contributed to decisions not to raise the degree of pressure on bank reserve positions
despite rapid growth of the monetary aggregates (especially Ml). After the
Plaza, similar concerns contributed to similar decisions. On the other hand,
throughout the period, the FOMC was alert to the danger that a precipitous
drop in the dollar might contribute to inflationary pressures or erode the confidence of foreign investors whose capital was essential to finance the U.S. payments deficit. Especially late in 1985 and early in 1986, this concern provided
a countervailing argument against efforts to ease the degree of pressure on
bank reserves.
In early 1986, a division developed within the FOMC, and especially within
the Board of Governors, concerning the advisability of further easing of monetary policy. Believing that the pace of expansion was becoming very sluggish
and that dangers of a resurgence of inflation were remote, the four Reagan
appointees to the Board of Governors favored some further easing. The three
other governors, including Chairman Volcker, and most of the Federal Reserve
bank presidents on the FOMC were unpersuaded of the need for further easing
and feared the possible consequences for the dollar. On 24 February 1986,
by a four-to-three vote, with Chairman Volcker in the minority, the Board of
Governors approved the request of the Dallas Federal Reserve Bank to reduce
its discount rate by half a percentage point.
At a meeting later the same day, this decision was rescinded by unanimous
vote of the Board. The Board’s Annual Report contains the following explanation of the shift: “Members who favored a reduction of the discount rate on
domestic grounds decided that a delay of limited duration would be acceptable,
given the outlook for easing actions by at least some other major central banks
during the next couple of weeks, if not within the next few days.” It should be
added that a number of requests for discount rate cuts were made by Federal
Reserve banks in January and February 1986 and were rejected by the Board
of Governors. Acceptance of these requests would probably not have been
enormously troubling to domestic or international financial markets. An open
split of the Board of Governors that undercut the authority of the chairman,
however, would have been quite a different matter.
The key economic event of 1986 was the dramatic drop in world oil prices
and its impact on both inflation and economic activity, Reflecting the sharp
decline in energy prices, the CPI fell in February, March, and April. For the
twelve months of 1986, consumer prices rose only 1.1 percent, compared with
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Monetary Policy
3.8 percent in 1985, 3.9 percent in 1984, and 3.8 percent in 1983. Economic
activity in the energy-producing states was strongly negatively effected by the
drop in oil prices. In addition, many U.S. manufacturing industries were continuing to feel the adverse impact of the strong dollar. As the data came in
during the year, they indicated moderate real growth during the first quarter, a
very sluggish second quarter, and then stronger but still relatively slow growth
during the second half. Years later, revised estimates of real GNP would show
a 6.6 percent growth rate for the first quarter, a - 1.8 percent growth rate in the
second quarter, a 0.8 percent growth rate in the third quarter, and a modest 2.3
percent growth rate in the fourth quarter. These figures, however, were not the
estimates on which the Federal Reserve depended in deciding on monetary
policy.
As evidence of the effects of the oil price decline became available, the
Federal Reserve responded with actions to reduce interest rates. In coordination with other important central banks, the discount rate was cut half a percentage point to 7 percent on 6 March. Further half percentage point cuts were
authorized on 18 April, 10 July, and 20 August, bringing the discount rate
down ultimately to 5.5 percent-its lowest level for the decade. The FOMC
directed or permitted substantial reductions in the Federal funds rate from
slightly above 8 percent in January, to slightly below 7 percent in June, and
then to 6 percent or slightly lower for July-November. Because of an extraordinary bulge of demand for transactions balances associated with provisions of
the Tax Reform Act, the funds rate spiked up to nearly 9 percent for a few days
in December but fell back to 6 percent in early January 1987.
In taking these actions, the Federal Reserve was often responding to developments in credit markets rather than leading market interest rates downward.
In this regard, it is noteworthy that, between January and July, yields on longerterm Treasury bonds and notes fell more than either yields on three-month
Treasury bills or the Federal funds rate. Except for the last downward step on
20 August, the reductions in the discount rate were clearly needed to catch up
with developments that had already occurred in credit markets.
On the other hand, the Federal Reserve did not strongly resist declines in
market interest rates during the first half of 1986 and did not act to push interest
rates upward as the monetary growth accelerated in the second half. Specifically, except for a brief period early in the year, M1 consistently grew well
above the upper limit of its target range, and it ended 1986 with more than
double the maximum prescribed growth of 8 percent. M2 briefly fell slightly
below the lower (6 percent) limit of its desired growth range during the first
quarter but then accelerated to reach the (9 percent) upper limit of its range by
year’s end. M3 grew along the 9 percent upper limit of its desired range for
essentially the entire year.
Judged either by growth rates of monetary aggregates or by the behavior of
interest rates, monetary policy was quite expansionary during 1986-for the
second year in a row. Thanks to the drop in oil prices, however, real economic
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Michael Mussa
growth slowed temporarily during 1986 (with a sharp downturn in energyproducing states), and the overall inflation rate (including energy prices) declined to the lowest level since the early 1960s. Thus, at the end of 1986, the
U.S. economy had enjoyed four years of business expansion and five years with
the annual inflation rate remaining at or below 4 percent.
It should be added that economic activity expanded very vigorously during
1987 and that, despite the stock market crash of October 1987, expansion continued at a fairly rapid pace during 1988. With the slowing of the growth of
real consumption spending and real government spending, improvements in
net exports and in investment were the keys to continued overall growth. Specifically, in late 1986, U.S. real exports, which had shown no net growth since
1980, began to expand rapidly, recording a 50 percent rise during the next four
years. The gain in exports also helped spark significant increases in real business investment in plant and equipment. The expansionary monetary policy of
1985-86, operating through the exchange rate as well as through interest rates,
was an important contributing cause to these developments. This same expansionary monetary policy was probably also a key underlying cause of the increase of inflationary pressures during the late 1980s.
2.5.5
A Flexible and Credible Policy
For four and a half years, beginning in the summer of 1982, the monetary
aggregates grew, on average, quite rapidly-at rates that in the late 1970s
would have implied very rapid inflation. Clearly, there were important shifts
during this period in the relations between the growth of monetary aggregates
and the growth of nominal GNP. To some extent, these shifts could be understood as responses of demands for various monetary aggregates to changes in
interest rates or to changes in interest elasticities of demands for these aggregates arising from banking regulations and the introduction of new forms of
deposits. In any event, on the whole, the Federal Reserve made appropriate
judgments about the nature and magnitude of these shifts. It provided monetary
growth sufficiently rapid to support vigorous economic expansion without generating increased inflationary pressures-at least not pressures that became
apparent before the end of 1986.
Moreover, the Federal Reserve was able to sustain quite rapid monetary
growth over an extended period without generating intense fears it was fueling
a resurgence of rapid inflation-fears that might have necessitated a monetary
tightening that would have cut short the business expansion. Thus, in the bloodbath of the 1981-82 recession, and in the brief monetary tightening during
1984, the Federal Reserve had firmly established its credibility as an inflation
fighter. It was then able to utilize this credibility to pursue a more flexible
monetary policy to promote economic expansion from late 1982 through 1986.
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Monetary Policy
2.6 Keeping the Demon at Bay
During the final three years of the 1980%with one brief interlude, the general stance of monetary policy shifted from fueling economic expansion to
resisting the rise of inflation. The move to tighten monetary policy began early
in 1987 and continued until the stock market crash on 19 October. For the next
five months, monetary policy was primarily directed at reducing instability in
financial markets and avoiding recession. Beginning in late March 1988, amid
signs of continued economic expansion and with some indications of rising
inflationary pressures, monetary policy became progressively tighter until June
1989. Subsequently, while the growth of monetary aggregates remained quite
sluggish, the Federal Reserve eased the Federal funds rate gradually downward. During this three-year period, as was the case earlier, developments in
the economy, rather than the behavior of the monetary aggregates, exerted the
decisive influence on Federal Reserve decisions about the Federal funds rate
and the discount rate.
2.6.1 A Move toward Tightening
More specifically, during the winter of 1987, the Federal funds rate remained at essentially the same level as during the fall of 1986. With the Louvre
Accord on 22 February, resistance to further significant depreciation of the
dollar became an officially stated policy of the U.S. government. At its meeting
on 3 1 March, the FOMC devoted “a good deal of attention . . . to the implications of the currently strong downward pressure on the dollar in foreign exchange markets.” The committee agreed that “the conduct of open market operations needed to be especially sensitive to any tendency for the dollar to
weaken significantly further.” During April, the Federal funds rate was pushed
up about fifty basis points, apparently to support internationally coordinated
efforts to resist further dollar depreciation. At the regular meeting on 19 May
1987, the FOMC agreed that “open market operations . . . would be directed
toward some degree of reserve pressure beyond that sought in recent weeks
(but not necessarily greater than that prevailing recently).” This action was
motivated both by concern about the recent increase in inflation (the CPI rose
at a 5.9 percent annual rate between December and March) and by continuing
worries about the dollar.
During the first six months of 1987, growth of all the monetary aggregates
slowed considerably from the rapid pace set in 1985 and 1986. The slowdown
in January and February reflected the collapse of the year-end bulge of demand
for transactions balances generated by the Tax Reform Act, but the slow
growth in later months suggested significant tightening of monetary policy.
Specifically, by the end of June, M2 was well below the lower limit of the
5.5-8.5 percent growth range established by the FOMC, and M3 was near to
the lower limit of its 5.5-8.5 percent desired growth range. For the first half of
1987, M1 grew at a 5.1 percent annual rate, nearly 11 percentage points below
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Michael Mussa
its growth rate during 1986. For the FOMC, which had abandoned targets for
M1 for 1987, this slowdown may have had little significance. However, for
monetarists who focus on changes in the growth rates of monetary aggregates
as a key indicator of shifts in the stance of monetary policy, it was important
further evidence of a substantial tightening of monetary policy.
From June through mid-August, the dollar recovered slightly and then stabilized in foreign exchange markets, owing apparently to more favorable news
about the U.S. trade balance. Available data showed that the U.S. economy
was continuing to expand at a moderate pace. Recent price data showed that
inflation had fallen off somewhat from the relatively high rates of the first
quarter. Also, it became increasingly apparent that the federal deficit would
register a large decline for the fiscal year ending on 30 September. Reflecting
this good news on all fronts, stock prices continued to rise, with the Dow Jones
industrial average recording a peak of 2,722 on 25 August. In this brief period
of calm before the storm, on 11 August 1987, Alan Greenspan replaced Paul
Volcker as chairman of the Federal Reserve Board.
2.6.2 The Crash
In late August, disappointing news about the U.S. trade balance, together
with firming in foreign interest rates, brought the dollar under renewed downward pressure. Market interest rates in the United States moved up in sympathy
with foreign interest rates and also (it appeared) in anticipation of tightening
by the Federal Reserve. On 4 September, the Board of Governors raised the
discount rate from 5.5 to 6 percent. Pressures on bank reserves were also increased at this time, and the Federal funds rate was pushed up about fifty basis
points to slightly over 7 percent. At the FOMC meeting on 22 September, this
increase in the funds rate was affirmed with a directive calling for maintenance
of “the degree of pressure on reserve positions sought in recent weeks” and
with an increase in the tolerance range for the Federal funds rate from 4-8
percent to 5-9 percent. These actions were taken with M2 substantially below
the lower limit of its target range and with M3 slightly below the lower limit
of its range. Available information indicated continued, moderately strong
business expansion. There was no direct evidence of any significant acceleration of inflation, but recent declines in unemployment and increases in rates of
capacity utilization raised worries that inflation might accelerate.
Short-term interest rates in Japan and West Germany moved further upward
in late September and the first half of October. The Federal funds rate moved
up to 7.26 percent for the week ending on Wednesday, 23 September, then up
to 7.56 percent for the week ending on 30 September, then down to 7.43 percent for the week ending on 7 October, then up to 7.59 percent for the week
ending on 14 October, and finally up to 7.76 percent on Thursday and Friday
of that week. These increases in the Federal funds rate were not mandated by
the FOMC directive of 22 September. The explanation given in the official
record of the FOMC meeting of 3 November 1987 states that computer prob-
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Monetary Policy
lems at a Reserve bank contributed to an exceptional increase in member bank
borrowing (and hence in the funds rate) during the period from 22 September
to 2 October. With respect to the behavior of the Federal funds for 5-16 October, the official record states, “Federal funds and other interest rates subsequently rose through mid-October as market participants appeared to anticipate monetary tightening in an environment of firmer policy abroad, concerns
about the dollar, and pessimism about the prospects for domestic inflation.”
Thus, the Federal Reserve claims to have done nothing explicit to tighten
monetary policy further during the two weeks immediately before 19 October.
Indisputably, however, the Federal Reserve allowed market participants “to anticipate monetary tightening” when it could surely have disabused them of
such anticipations.Moreover, the actions of the Federal Reserve earlier in 1987
clearly made such anticipations of monetary tightening entirely rational.
The first paragraph of the lead story of the Wall Street Journal on Tuesday,
20 October 1987, succinctly and accurately describes the event of the preceding day: “The stock market crashed yesterday.” Three months later, while serving as a member of the Council of Economic Advisers, I received a note from
an able, intelligent, and normally sensible member of the White House staff
suggesting that the word crash, which appeared many times in the description
of the main macroeconomic events of 1987, be deleted entirely from the 1988
Economic Report of the President. Thus, while the Federal Reserve wished to
deny (perhaps accurately) that it had done anything explicit to bring on the
stock market crash, some in the administration wished to deny that the crash
had occurred at all.
The apparent tightening of monetary policy in early October was surely one
of several economic fundamentals that contributed to the 400-point slide in the
Dow Jones Industrial Average during the two weeks before the crash, including
the 108-point drop on Friday, 16 October. The 508-point drop in the Dow on
Monday, 19 October, however, is not plausibly explained by economic fundamentals. It reflected pure panic.13Moreover, knowing now that the crash had a
relatively benign outcome, it might even be argued that monetary tightening in
the weeks before the crash helped restore a sense of reality to a stock market
that had risen significantly beyond the level justified by economic fundamentals.
2.6.3 Aftermath
In any case, the response of monetary policy to the crash was massive, immediate, and appropriate. A terse public statement, released on the morning of
Tuesday, 20 October, stated, “The Federal Reserve, consistent with its respon13. An opinion survey of financial market participants concerning the causes of the stock market
crash was conducted for the Brady Commission. The results (summarized in the commission report) indicated that ‘‘economicfundamentals,” including increases in interest rates, were key factors in generating the slide in stock prices during the two weeks before the crash. The crash itself,
however, was attributed to panic in the marketplace.
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Michael Mussa
sibilities as the nation’s central bank, affirmed today its readiness to serve as a
source of liquidity to support the economic and financial system.” In the morning and early afternoon of 20 October, the Open Market Desk pumped $17
billion into the banking system-an amount equivalent to more than 25 percent of bank reserves and 7 percent of the monetary base. The Federal Reserve
also let commercial banks know that it expected banks to continue to supply
credit to other participants in the financial system, including loans to brokerdealers to carry their inventories of securities.
After a further, sickening decline on Tuesday morning, stock prices miraculously turned upward in the afternoon, and the Dow closed the day with a 102point gain. Violent oscillations in stock prices continued through the week and,
indeed, for the remainder of 1987. However, by Friday, 24 October, intense
worry and nervousness replaced uncontrolled panic as the dominant mood in
financial markets. As things calmed down and the crisis demand for liquidity subsided, the Federal Reserve withdrew most of the high-powered money
that it had injected on 20 October. To avoid adding to turbulence in financial
markets, it did so in a manner that kept the Federal funds rate very stable at
about 6.75 percent-a drop of 1 percentage point from the level just before
the crash.
The decline in stock market prices between August and late October reduced the value of marketable assets held by Americans by approximately $1
trillion. Since much of this wealth loss represented a reversal of gains made
earlier during 1987 (and not yet fully incorporated in consumer spending), at
the Council of Economic Advisers (CEA) we estimated that the direct negative
effect of the decline in wealth on consumer demand would most probably be
in the range of $25-$30 billion. The CEA projected that the effect on the economy would be about a 1 percent reduction of real GNP below the path that it
would otherwise have followed during the next three or four quarters. With
exports expected to contribute significantly to demand for U.S. products (the
heritage of the decline in the dollar since early 1985), real GNP was officially
forecast to rise by 2.4 percent during 1988. If achieved, such growth would be
a not entirely unwelcome slowdown from the rapid pace of economic advance
during 1987. However, at least at the CEA, two conditions were thought to be
critical in order to achieve such a favorable outcome: avoidance of a further
sharp drop in stock and bond prices and a monetary policy that was adequately
supportive of economic expansion.
The FOMC anticipated that the lowering of pressures on bank reserves and
the reduction in the Federal funds rate in the period immediately following the
crash would lead to more rapid growth of the monetary aggregates. The operating procedures adopted by the Federal Reserve in the aftermath of the
crash, however, placed little emphasis on achieving projected growth rates for
monetary aggregates. Instead, they focused on maintaining stable conditions
in money markets, which effectively amounted to pegging the Federal funds
rate within a narrow range close to 6.75 percent.
In the event, the Federal Reserve’s operating procedure delivered very slow
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Monetary Policy
growth of the monetary aggregates during the ten weeks following the crash.
M1 actually declined at about a 4 percent annual rate during November and
December, while M2 and M3 grew at rates of about 1.5 and 3 percent, respectively. At least at the CEA, there was considerable concern that monetary policy was not doing enough to forestall the possible negative effects of the crash
on economic activity. The concern on the other side (as expressed in the “Record” of the FOMC) was that any visible move to ease monetary policy further
by lowering the Federal funds rate “would not be desirable currently, especially
in the light of the dollar’s weakness and the risks to domestic financial markets
and the economy that a sharp further decline in the dollar would incur.”
The decline in U.S. interest rates relative to interest rates in Japan and West
Germany after the crash did contribute to a modest decline of the dollar in
late October. Disappointing news about the U S . trade balance and the U.S.
government’s apparent laissez-faire attitude toward the dollar contributed to a
further 8 percent decline in the dollar by year’s end. Clearly, the Federal Reserve’s intent was not to resist these declines in the dollar. Rather it was to
avoid the risk of instigating an international financial crisis by permitting a
reduction in the Federal funds rate that might be interpreted as an explicit attempt to drive down the dollar.
Since the Federal Reserve did not reduce the Federal funds rate further to
stimulate modestly stronger monetary growth, we do not know whether there
was really any serious danger that such a move would generate an international
financial crisis. On the other hand, since a modest increase in inflationary pressures, rather than recession, turned out to be the main macroeconomicdevelopment of 1988, it does not appear that more rapid monetary growth was really
essential during the weeks following the stock market crash. In retrospect,
therefore, the Federal Reserve appears to have acted wisely in not pushing the
Federal funds rate further downward in order to achieve more rapid monetary
growth at the end of 1987.
Economic data available from late October through mid-December indicated that the economy was continuing to expand at a moderate pace during
the period before the crash but provided little information about postcrash developments. Data for the automobile industry, however, did show a sharp
downturn in sales and a buildup in inventories. When estimates of fourthquarter GNP did become available in January 1988, they indicated that real
GNP had continued to grow at a moderate pace but that much of this growth
was accounted for by inventory accumulation rather than by growth of final
sales-a signal of future weakness in business activity. Meanwhile, the growth
rates of monetary aggregates picked up considerably in January, while the dollar recovered somewhat in foreign exchange markets. The Federal Reserve reacted to these developments by reducing the pressure on bank reserves and
easing the Federal funds rate downward by about twenty-five basis points to
just over 6.5 percent. Subsequently, the dollar declined slightly against some
foreign currencies, but this appeared to be more in response to poorer-thanexpected trade figures rather than to the slight easing in the funds rate.
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2.6.4 A Return to Tighter Money
By the FOMC meeting on 29 March, recent data showed that the economy
was growing more strongly than previously anticipated. Concern was expressed about prospects for prices and wages, but “aggregate measures of
prices and wages had not yet shown any sustained tendency to accelerate.”
Monetary growth (except for M1) had remained relatively robust since January.
In this environment, the FOMC directed “a slight increase in the degree of
pressure on reserve positions.” It also decided to continue the shift (begun in
January) of the operating procedures toward achieving the desired degree of
pressure on bank reserves rather than placing special emphasis on maintaining
stable conditions in the money markets.
The trend of monetary policy established at the FOMC meeting on 29 March
continued through the remainder of 1988 and the first half of 1989. Economic
data indicated that the expansion was continuing, although generally at a somewhat slower pace as time passed. On balance, data on prices and wages indicated a gradual, mild increase of inflationary pressures, with the (six-month)
annualized rate of increase in the CPI rising to 5.7 percent in June 1989.
Growth of the monetary aggregates slowed progressively. Specifically, for the
six months ending in June 1988, the annualized rates of growth of M1, M2,
and M3 were 7.7,7.9, and 8.2 percent, respectively. For the six months ending
in December, these monetary growth rates were reduced to 2.2, 3.1, and 4.8
percent, respectively.Then, for the six months ending in June 1989, these monetary growth rates fell to -3.5, 1.9, and 3.4 percent, respectively.
Meanwhile, the Federal funds rate was pushed up progressively and substantially from 6.6 percent in March 1988, to 7.5 percent in June, then to 8.75
percent in December, and subsequently to 9.8 percent in March, April, and
May 1989, before declining somewhat to 9.5 percent in June 1989. The discount rate was raised half a percentage point to 6.5 percent in August 1988
and by another half a percentage point to 7 percent in February 1989. The
increase in the Federal funds rate by about double the increase in the inflation
rate, together with the very slow monetary growth during the first half of 1989,
indicates a very tight monetary policy. The Federal Reserve was clearly indicating its determination not to “fall behind the curve” in the effort to resist
rising inflation-as it had with such disastrous consequences during the 1970s.
The 1988 presidential election occurred in the midst of these actions to
tighten monetary policy. The presidential contenders, however, happily
avoided any serious discussion of monetary policy. Republicans were relieved
that the economy survived the crash without a recession and wished to avoid
any criticism of the Federal Reserve that would only stir up needless controversy. The Democrats also saw nothing to gain from criticizing the Federal
Reserve and sought to credit it, rather than the administration,with the success
in reducing inflation and managing recovery. Thus, the Federal Reserve was
left to do its job without the political pressures often associated with a presidential election.
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By mid-May 1989, the available data began to show significant slowing in
the pace of economic advance, and this was confirmed by information received
in subsequent weeks and months. Also, owing primarily to a partial reversal
of earlier increases in energy prices, measures of inflation generally showed
significant moderation during the summer and autumn of 1989. In this environment, the Federal Reserve shifted to a somewhat less tight monetary policy.
For the Federal funds rate, the small decline in June was followed by a fiftybasis-point decline in July and by a further drop to 8.5 percent in November.
Growth of M3 remained quite sluggish during the second half of 1989,and M3
slipped slightly below the lower limit of its target range. In contrast, growth of
M2 rose to nearly an 8 percent annual rate in the second half, moving M2 from
below the lower limit of its target range in May to just below the midpoint of
this range by year’s end. M1 shifted from significantly negative growth during
the first half of 1989 to positive growth at about a 5 percent rate and was essentially unchanged for the year as a whole.
It is noteworthy that, as the Federal Reserve moved to tighten monetary policy in the spring of 1988, the dollar began to rise in goreign exchange markets.
The upward movement generally continued until June 1989, and the dollar
remained quite strong for some time after monetary policy began to ease during the summer of 1989. Initially, the strengthening of the dollar was regarded
as desirable both in terms of reducing inflationary pressures in the United
States and in reference to internationally coordinated efforts to enhance exchange rate stability. By late 1988, however, the appreciation of the dollar
reached the point where the U.S. Treasury and foreign governments intervened
actively, but generally not successfully, to resist further dollar appreciation.
The worry (at least at the U.S. Treasury) was that a stronger dollar might seriously impede further reductions in the U.S. trade and current account deficits.
The Federal Reserve carried out the foreign exchange interventions directed
by the Treasury and, as is traditional, intervened on its own account in support
of Treasury operations. However, the Federal Reserve did not alter its monetary
policy in order to resist appreciation of the dollar. Monetary policy remained
directed toward its primary objectives of fostering price stability and promoting sustainable economic growth.
2.6.5
Looking Forward into the 1990s
The scope of this discussion of monetary policy properly finishes with the
end of 1989. However, it is appropriate to mention two developments during
1990 that are relevant for assessing monetary policy in the 1980s. First, inflation accelerated briefly in early 1990 owing primarily (but not exclusively) to
an extraordinary 2 percent bulge of consumer prices in January. This raised the
six-month annualized rate of change in the CPI to 6 percent for the first half
of 1990, providing further evidence that the Federal Reserve was not merely
tilting at windmills in its efforts to resist the acceleration of inflation during
the late 1980s. Second, economic expansion was very sluggish during the first
half of 1990, and recently revised GNP data also show very sluggish growth
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Michael Mussa
during most of 1989. Specifically, for the five quarters starting with the spring
of 1989, the most recent (July 1990) estimates of the annualized growth rates
of real GNP are the following: 1.6, 1.7,0.3, 1.7, and 1.2 percent, respectively.
Preliminary evidence for the summer quarter of 1990, even before Saddam
Hussein’s invasion of Kuwait, indicates that, at best, economic expansion is
continuing at a very slow pace.
No doubt, factors other than tight monetary policy contributed to this recent
sluggishness in real economic growth. Nevertheless, it illustrates that determined efforts by the Federal Reserve to resist increases in inflation have a
short-run cost in terms of the real growth of the economy. It also raises the
question of whether the Federal Reserve was perhaps a little too forceful in its
efforts to resist inflation during 1988-89 and a little tardy in its more recent
actions to ease monetary policy. Any hope of providing a reasonably clean
answer to that question, however, has probably become another victim of Saddam Hussein’s aggression. If the U.S. economy falls into recession during the
second half of 1990 or in early 1991, it will be extremely difficult to disentangle the effects of Federal Reserve policy before the 2 August invasion of
Kuwait from the direct and indirect effects of the recent substantial rise in
world oil prices. Moreover, the Federal Reserve now faces the delicate task of
dealing both with negative output and employment effects of the rise in oil
prices and with a short-term rise of inflationary pressures that is not the consequence of an excessively easy monetary policy.
2.7
Hail to the Chief
Since the Federal Reserve exercises very considerable independence in its
conduct of monetary policy, this essay has focused primarily on the actions of
the Federal Reserve. However, the Federal Reserve does not operate in a political vacuum, and its monetary policy must at least take some account of the
economic policies of the administration and the Congress. In this regard, the
key question for the 1980s is, What did Ronald Reagan do to win the great
battle against inflation?
My answer may not be entirely unbiased. As a member of the Council of
Economic Advisers for more than two years (from 1986 to 1988), it was part
of my job to defend, as best as possible, the economic policies of the Reagan
administration. However, I would identify the primary contributions of Ronald
Reagan to the effort to reduce inflation as occurring much earlier in his administration.
2.7.1 Sending a Message
When the air traffic controllers went out on an illegal strike against the federal government in the spring of 1981, Ronald Reagan fired them. Beyond the
federal workers who were directly affected, this action sent an important message that the climate of labor-managementrelations had changed. The general
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public support for the firing of the air traffic controllers, together with the results of the 1980 election, indicated forcefully that the American people
wanted something serious done about the problem of inflation and would support tough measures to accomplish the task. The import of this message was
not lost at the Federal Reserve or among those who exercised more direct influence over the setting of prices and wages.
There is no reliable way to estimate the extent to which the changed climate
of labor-management relations may have diminished inflationary pressures in
the early 1980s. It is noteworthy, however, that studies based on the experience
of the 1960sand the 1970sgenerally suggested that a prolonged period of very
high unemployment might be required in order to make substantial progress
in reducing rates of nominal wage g r 0 ~ t h . In
I ~the recession of 1981-82, the
unemployment rate did rise to a postwar peak, and it remained relatively high
through the initial stages of recovery. However, even given these high rates of
unemployment, the drop in the rate of wage inflation during the early 1980s
was surprisingly rapid.
2.7.2 Cutting Taxes
Along more traditional lines, but for reasons that are not widely appreciated,
the Reagan administration’s fiscal policy may have aided the effort to reduce
inflation, or at least ameliorated the recessionary consequences of the tight
monetary policy that was the essential weapon in the battle against inflation.
From the perspective of Keynesian open-economy macroeconomics, the classic policy prescription to minimize the unemployment costs of reducing inflation is a tight monetary policy combined with an easy fiscal policy. This prescription is based on the presumption that monetary policy has a comparative
advantage in influencing the price level while fiscal policy has a comparative
advantage in affecting the level of output and employment. Moreover, in an
open economy operating under a floating exchange rate, the combination of a
tight monetary policy and an easy fiscal policy tends to appreciate the foreign
exchange value of domestic currency, which assists in reducing inflation.I5
Of course, given its generally anti-Keynesian bias, the administration would
14. A classic analysis of this issue is provided in Tobin (1980). Many other analyses also suggested that a prolonged period of high unemploymentwould be necessary to make much progress
in reducing the core rate of wage inflation.
15. Even if an expansionary fiscal policy was desirable for macroeconomics stabilization purposes during the early 198Os, it does not necessarily follow that the Reagan administration’s fiscal
policy was entirely appropriate. On the supply side, the effects of the tax cuts may not have been
as large as their advocates supposed. On the demand side, perhaps the tax cuts legislated in 1981
(and partially reversed in 1982) were too much of a good thing. Moreover, if the Reagan administration’s fiscal policy was helpful from a Keynesian macroeconomicperspective, this should probably be regarded as a fortunate accident. It should not be taken as a lesson that fiscal policy can
often be used, in a flexible manner, for macroeconomic stabilization purposes. On the other hand,
the practical and political barriers to the flexible use of fiscal policy, and the serious problem of
getting the timing right, do not obliterate the €avorable effect of an important fiscal policy action
that fortuitously occurs at about the right time.
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not usually advance such arguments. Instead, it would point to the favorable
“supply-side” effects of the Reagan tax cuts both in encouraging increased
output and employment and in reducing inflationary pressures. Probably both
lines of argument contain some element of truth. In any case, the inflation rate
did come down more rapidly than was widely expected, the dollar did appreciate strongly in foreign exchange markets, and the U.S. economy did recover
very rapidly from the recession of the early 1980s-generally more rapidly
than other industrial countries that pursued different combinations of monetary
and fiscal policy.16
At the Federal Reserve, the administration’s fiscal policy was generally regarded as more of a problem for the conduct of monetary policy than as a
benefit. During 1982, it was anticipated that the phasing in of the tax cuts
legislated in 1981 would help propel the economy out of recession. However,
the dominant view expressed by the Federal Reserve was that the large actual
and prospective federal deficits pushed interest rates higher, eroded confidence
in the government’s anti-inflation program, and impaired the Federal Reserve’s
policy to curb inflation without excessive costs in terms of output and employment. This complaint about the budget deficit was repeated, almost as a religious incantation, in virtually every public statement by the Federal Reserve.
In particular, the “Monetary Policy Report to Congress” of 20 July 1982
(quoted earlier) puts the issue as follows:
The policy of firm restraint on monetary growth has contributed importantly
to recent progress toward reducing inflation. But when inflationary cost
trends becomes entrenched, the process of slowing monetary growth can
entail economic and financial stresses, especially when so much of the burden of dealing with inflation rests on monetary policy. . . .
The present and prospective pressures on financial markets urgently need
to be eased not by relaxing discipline on money growth, but by adopting
policies that will ensure a lower and declining federal deficit.
Thus, monetary policy gets the credit for reducing inflation, while entrenched inflationary cost trends and the federal deficit get the blame for the
recession and high interest rates. Ironically, as previously noted, on the very
day that this “Monetary Policy Report” was issued, the Federal Reserve began
precisely the relaxation of monetary policy that it argues against in this statement. During the next five months, interest rates tumbled downward under the
16. The administration’seasy fiscal policy may also have interacted with the Federal Reserve’s
tight monetary policy through their combined impact on the foreign exchange value of the dollar,
which, in turn, influenced both inflation and economic activity. Martin Feldstein has long been a
leading proponent of this view, arguing that the actual and expected fiscal deficit was a leading
cause of dollar appreciation during the early 1980s-a development that helped bring down the
inflation rate (see, e.g., Feldstein 1986). Feldstein has also argued that the Federal Reserve’s monetary policy determined primarily the course of nominal GNP. In the face of this monetary policy,
the administration’s expansionary fiscal policy contributed to greater growth of real GNP and to
less of an increase in the price level.
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impact of a much easier monetary policy, despite continued expansion of the
federal deficit.
Of course, the administration’s fiscal policy (and the large deficits to which
it contributed) did not push interest rates lower. Qualitatively, the effect must
have been in the other dire~ti0n.I~
The problem for the Federal Reserve was
that it tended to be blamed for high interest rates, and, with some justification,
it wanted to shift part of the blame to the administration and the Congress.
However, from the perspective of the overall conduct of macroeconomic policy, in the circumstances of the early 1980s, an expansionary fiscal policy that
may have put some upward pressure on interest rates was not necessarily inappropriate. In contrast, late in the 1980s, the key task for macroeconomic policy
was to resist a rise of inflation, with an economy functioning relatively near to
full capacity and with substantial continuing deficits in the trade and current
accounts. In this situation, it might have made sense to rely somewhat less on
a tightening of monetary policy to resist rising inflation. Certainly, it would
have been desirable to make somewhat greater progress in reducing the federal deficit.I8
2.7.3
Staying the Course
Probably the most important contribution of President Reagan to the fight
against inflation was not something that he did but something that he did not
do. During the critical period of 1981-82, he did not pressure the Federal Reserve to back off of its tight monetary policy before a convincing victory had
been won over the demon of inflation. Despite its much vaunted “political independence,’’ the Federal Reserve could not persist in a tight monetary policy
during a deep recession against the determined opposition of a popular president. Nicholas Biddle and the Second Bank of the United States were taught
that lesson by Andrew Jackson, and, for eighty years thereafter, the United
States had no central bank. More recently, one can imagine what Lyndon John17. There are many papers dealing with the effects of the governmentbudget deficits on interest
rates. They do not all reach the same conclusion. For one view, see Blanchard and Summers
(1984). For an alternative view, see Barro and Sala-i-Martin (1990). My reading of the evidence
is that it is difficult to make a convincing case that movements in the federal deficit (either actual or
anticipated)were the dominant cause of movements in nominal or real interest rates-the timing is
just not right. The enormous swings in interest rates from the summer of 1979 through early 1981
are not associated with dramatic movements in fiscal policy. The large drop in interest rates after
the summer of 1982 does not correspond to news about exceptionally favorable developments
for the deficit. The rise in interest rates during 1984 does not correspond to unforeseen adverse
developments for the deficit. The decline in interest rates during 1985-86 is not generally associated with favorable news on the deficit. During 1987, the rise in interest rates before the stock
market crash was associated with an unexpectedly large decline in the deficit. The rise of interest
rates from early 1988 through the spring of 1989 corresponds to no significant development concerning the deficit. In all these episodes, it is far easier to see the influence of monetary policy
than of fiscal policy on the behavior of interest rates.
18. As discussed in chap. 2 of Economic Report ofthe President, 1987, many of the arguments
for reducing the federal deficit do not depend on whether the deficit has a dominant effect on the
behavior of interest rates.
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Michael Mussa
son or Richard Nixon would have done had their personal political popularity
dropped substantially and their party faced significant midterm electoral losses
because of an excessively tight monetary policy directed by a group of appointed officials at the Federal Reserve.
In this connection, it should be emphasized that, while the Federal Reserve
enjoyed some support for its tight policy in the financial community, it was not
popular with the home builders and construction workers, with the automakers
and autoworkers, with the farmers and farm implement makers, and with the
whole array of business and labor that felt the pain of tight money, high interest
rates, and recession. Congress generally pays attention to the financial community on financial matters. However, Congress always pays close attention to
expressions of pain and complaint from constituents back home. Hence, tight
money is rarely popular on Capitol Hill. In 1981-82, many members of Congress and congressional leaders from both parties were highly critical of the
Federal Reserve’s tight monetary policy. Senator Robert Byrd, leader of the
Democratic minority, circulated draft legislation commanding the Federal Reserve to reduce interest rates. Senator Baker, leader of the Republican minority,
did not support this legislation but was deeply concerned about the Federal
Reserve’s tight policy and reportedly expressed those concerns directly and
repeatedly to Chairman Volcker.
Senior administration officials, both in the White House and at the Treasury,
generally shared the view that the Federal Reserve was keeping monetary policy too tight for too long. A consensus to force the Federal Reserve to relax its
policy never developed either among senior officials in the administration or
in the Congress. However, there can be little doubt that, had Ronald Reagan
pulled on his cowboy boots and led a lynch mob from the south lawn of the
White House down to Federal Reserve headquarters on Constitution Avenue,
he would have been joined not only by the members of his administration but
also by majorities from both parties in both houses of Congress, by the Washington representatives of a vast array of American businesses, and by a fair
number of foreign diplomats, particularly from heavily indebted countries.
For whatever reasons, Ronald Reagan did not do that. Instead, he campaigned through the dark and difficult days of the recession of 1981-82 on the
slogan “Stay the Course.”
2.8 Lessons from Defeat and Victory
In the early 1930s, the Federal Reserve made the Great Mistake. It failed to
resist, as actively and effectively as it could, the massive contraction of the
money supply between late 1929 and early 1933, thereby contributing to the
financial and economic devastation of the Great Depression and to all the horrors it helped engender. In the late 1960s and the 197Os, the Federal Reserve
made smaller but still important errors in the other direction. After contributing
to the rise of inflation through an inappropriately easy monetary policy in the
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late 1960s, in the early 1970s, and again in the late 1970s, the Federal Reserve
waited so long to take effective corrective action that the consequence was an
unnecessarily deep and prolonged recession.
In particular, during 1977 and 1978, monetary policy helped fuel the resurgence of inflation. The initial efforts to combat rising inflation beginning in
November 1978 were too timid. By the summer of 1979, in the face of the
second oil price shock, it became clear that the timid initial efforts to combat
rising inflation were ineffective and unpersuasive. Then, when the Federal Reserve finally did forcefully confront the inflationary demon in late 1979 and
early 1980, it retreated at the first sign of significant casualties, before the battle
had been won.
With its credibility badly damaged by its own past errors, the Federal Reserve rejoined the battle in November 1980 and, at the cost of a deep and
prolonged recession, fought through to a convincing victory. Subsequently
during the 1980s, the Federal Reserve successfully conducted a monetary policy that supported an exceptionally long and relatively vigorous economic
expansion, without a substantial rise in the rate of inflation. Three important
lessons can be learned, and apparently have been learned, from this experience.
2.8.1
Three Main Lessons
First, once the inflationary process has built substantial momentum and the
credibility of the central bank has been impaired, it takes a determined tightening of monetary policy to reduce significantly the rate of inflation and restore
confidence in a greater degree of future price stability. In principle, it might be
hoped that a gradual, persistent tightening of monetary policy would control
and ultimately diminish inflation without precipitating an economic downturn.
However, experience indicates that a recession of significant depth and duration is the virtually inevitable consequence of a successful attack on deeply
entrenched inflation. Efforts to avoid recession by stabilizing inflation once it
has risen to a relatively high rate do not have a happy history. Under such a
policy of monetary appeasement, the natural tendency is for the inflation rate
to be ratcheted upward in a never-ending spiral toward hyperinflation.
Ultimately, there is no escape from the short-term economic damage of a
determined effort to reduce inflation. The only option is postponement, which
makes both the problem of inflation and the pain of its cure far worse. The
Federal Reserve demonstrated that it learned this important lesson (perhaps
too well) when it pursued a very tight policy for twenty-one months from November 1980 to August 1982. Implicitly, it accepted that a deep and prolonged
recession was the necessary cost of gaining an important victory over the entrenched inflation that .was largely the consequence of its own earlier policies.
Second, as a corollary of the first lesson, it is a serious mistake for monetary
policy to allow the inflationary process to build substantial momentum before
determined action is taken to curb the rise of inflation. Such action is likely to
slow the pace of economic expansion and to raise the risk of recession. How-
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Michael Mussa
ever, it is generally better to take moderate risks in this direction before inflationary pressures rise significantly than to delay action until a serious economic
downturn becomes the likely consequence of necessary monetary tightening.
The Federal Reserve demonstrated its command of this lesson when it tightened monetary policy during 1984, during the first nine months of 1987, and
again during most of 1988 and 1989. It remains, of course, an open issue
whether the Federal Reserve went too far, or not quite far enough, in its recent
tightening of monetary policy. Regardless of the outcome, however, it is apparent that the Federal Reserve is not disposed to repeat the same mistakes of the
late 1960s and the 1970s.
Third, there is no unique quantitative guide to the monetary policy that best
serves the generally agreed on and intrinsically related objectives of promoting
maximum sustainable economic growth and assuring reasonable price stability. Instead, the central bank needs to examine a variety of indicators of the
current and prospective performance of the economy and to assess several
measures of the stance of its own monetary policy. This view-that the conduct of monetary policy requires judgment and discretion-has always governed the conduct of the Federal Reserve. Even during the period of relatively
serious targeting of growth rates of monetary aggregates from October 1979
until the summer of 1982, the Federal Reserve was always looking at the performance of the economy and developments in financial markets in deciding
on its policy.
The lesson of the late 1970sand the 1980sis that, in the turbulent and uncertain conditions likely to accompany a successful attack on entrenched inflation,
there is no alternative to discretion in the conduct of monetary policy. There is
also no escape from the responsibility to exercise that discretion wisely. On
the basis of this experience, however, it remains an open question whether a
more “rule-based” approach to the exercise of discretion in the conduct of
monetary policy would more successfully avoid the problems of entrenched
inflation or prolonged economic downturn.
2.8.2 The Meaning of Discretion
Economists have long disputed the virtues of “rules versus discretion” in the
conduct of monetary policy-fundamentally a religious controversy, intrinsically related to the age-old dispute over free will versus prede~tination.’~
On
19. Following the work of Kydland and Prescott (1977) and of Robert Barro and David Gordon
(1983), the recent academic literature has usually formulated the distinction between “rules and
discretion” in terms of the ability of the monetary authority to precommit its policy in some specific and enforceable manner. In practice, it is questionable whether this distinction is very meaningful or useful. The economic variables that are really of interest to the public and their elected
representatives(real economic growth, employment, and inflation) are not entirely under the control of monetary policy. The Federal Reserve could not realistically commit its policy to deliver
specific outcomes for these variables. On the other hand, it is far from clear that the public would
want specific commitments for those variables that the Federal Reserve can totally control if the
outcome was unfortunate for the variables that really matter.
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Monetary Policy
this issue, a highly relevant observation was made by Winston Churchill in his
autobiography,My Early Years: “My conclusion upon Free Will and Predestination . . . ,let the reader mark it, . . . they are identical.”
Similarly, if there is a “rule” for monetary policy, then whoever writes it can
revise it and whoever implements it must interpret it. Inevitably, some element
of discretion infects every “monetary rule.” Equally inevitably, the “discretionary” conduct of monetary policy is not whimsical and haphazard. The effort is
always to achieve the desired outcome on the basis of what experience suggests
to be the relation between actions taken and results achieved. Without some
degree of consistency and regularity, there is no meaningful monetary policy.
Thus, there is no sharp, clean distinction between “rules and discretion” but
rather a muddy issue of the reliance to place on particular relations and indicators in guiding the actual conduct of monetary policy.
In this regard, the experience of the late 1970s and the 1980s powerfully
illustrated the failure of interest rates to provide a continuously reliable guide
for the conduct of monetary policy. From 1976through 1979,the Federal funds
rate was pushed up in a series of steps to levels that would have indicated a
quite tight monetary policy in the context of the 1960s. However, during much
of this period, the inflation rate was moving upward as fast as or faster than
the Federal funds rate, and the Federal Reserve was falling behind the curve in
its efforts to combat the rise of inflation. The level of the Federal funds rate,
by itself, failed to provide a reliable indicator of the stance of monetary policy.
During the period of very tight monetary policy, from November 1980 until
July 1982, the level of the Federal funds rate was generally very high both
absolutely and in comparison with the rate of inflation. This fact, together with
information about the performance of the economy and the slow growth of the
narrow monetary aggregate MIA, correctly indicated a very tight monetary
policy. However, for much of the period from the summer of 1982 through
late 1986, the performance of the economy and the growth of the monetary
aggregates indicated a relatively easy monetary policy. During this period, the
Federal funds rate also generally remained well above the inflation rate. By the
standards of the 1960s or 1970s, the level of the Federal funds rate, adjusted
for inflation, would have suggested a very tight monetary policy. Thus, even in
combination with the inflation rate, the Federal funds rate failed to provide a
unique and completely reliable indicator of the stance of monetary policy.
On the basis of the experience of the late 1970s and the 1980s, similar conIn the academic literature, there is also the notion that the problem with “discretion” is that the
monetary authority cannot avoid the temptation to use it to surprise the public with greater than
anticipated inflation in order to drive output and employment above their sustainable equilibrium
levels. The practical relevance of this notion is also highly questionable. The Federal Reserve
made mistakes in allowing inflation to build up momentum in the late 1960s and the 1970s. It was
sometimes too timid in attacking inflation because of concern about the consequences for output
and employment. However, there is little factual support for the accusation that the Federal Reserve actively sought to deceive the public by knowingly creating greater than anticipated inflation.
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Michael Mussa
cerns apply to the use of monetary aggregates as the unique indicators of monetary policy. The key to the usefulness of monetary aggregates is a stable,
highly predictable relation between the behavior of these aggregates and the
behavior of economic variables of more fundamental interest, especially real
GNP, the price level, and nominal GNP. As illustrated in figure 2.10, for the
twenty years prior to 1980, the velocity of M1-the ratio of nominal GNP to
M1-exhibited a relatively stable, 3 percent trend rate of growth. After 1980,
this apparently stable relation between M1 (= MlB) and nominal GNP collapsed, with velocity declining sharply in the early 1980s and then remaining
essentially flat, on balance, for the remainder of the decade. Clearly, a monetary policy that targeted the growth rate of M1 on the assumption of a 3 percent
annual rate of increase in its velocity would have gone seriously, perhaps catastrophically, awry during the 1980s.
For M2, the trend behavior of velocity has remained essentially flat in the
1980s. However, there have been relatively large annual fluctuations in M2
velocity (i.e., fluctuations of 3 or 4 percent) that indicate that strict targeting
of the growth rate of this aggregate would, on some occasions, have created
serious difficulties.
Moreover, the usefulness of monetary aggregates as indicators of monetary
policy is seriously impaired when the growth rates of these aggregates give
disparate signals about the stance of monetary policy, as happened at several
points during the 1980s. In particular, looking at the critical period of the battle
against inflation from late 1980 through mid-1982, the growth rate of M2,
illustrated in figure 2.6 above, does not by itself indicate a particularly tight
monetary policy. Indeed, the growth rate of M2 during this period was marginally higher than the growth rate of M2 from early 1977 until October 1979,
when, judged by the actual behavior of the price level, monetary policy was
not firmly anti-inflationary. In comparison, the growth rates of M1 (= new
12
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-/
....................................
Fig 2.10 Velocity, various monetary aggregates, 1%0:1-199O:l
Note: Velocity equals GNP divided by the respective monetary aggregate.
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Monetary Policy
M1B) and especially of MIA (= old Ml), both illustrated in figure 2.5 above,
indicate a significantly tighter monetary policy from late 1980 to mid-1982
than during the late 1970s. Another example of significant disparity in growth
rates of different monetary aggregates occurs in 1985 and 1986. The growth
rate of M2 during this two-year period is only marginally higher than during
the period of tight monetary policy from late 1980 to mid-1982. In contrast,
M1 grows at an exceptionally rapid pace during 1985-86, both in comparison
with the period of tight monetary policy during 1981-82 and in comparison
with the period of rising inflation during the late 1970s.
Of course, monetarists would argue that much of the disparity in the growth
rates, and many of the movements in velocities, of different aggregates during
the 1980s can be explained by movements in interest rates and by shifts into
and out of newly created classes of deposits. Granted that this is correct, it
does not controvert the fundamental lesson that some degree of discretion is
required in the conduct of monetary policy. The only way to remove discretion
completely would be to specify a precise and invariant definition of the monetary aggregate to be targeted and a rate at which this aggregate should be made
to grow, month in and month out, regardless of virtually any condition or circumstance short of thermonuclear war. The experience of the 1980s indicates
that there are situations in which this sort of discretionlessmonetary rule would
perform rather poorly.
2.8.3 The Role of Monetary Aggregates
Given the inevitability of some degree of discretion in the conduct of U.S.
monetary policy, it remains relevant to ask what emphasis should be given to
monetary growth rates in guiding the Federal Reserve’s policy. On this issue,
the lessons of the 1970s and the 1980s are somewhat ambiguous. As previously discussed, strict targeting of monetary aggregates would have encountered severe difficulties in the turbulent economic and financial environment
of the early 1980s. On the other hand, it is clear that the Federal Reserve would
have avoided most of the error of contributing to the buildup of inflationary
pressures during the late 1970s if it had been more assiduous in achieving its
own announced monetary growth targets. Under those circumstances,much of
the economic and financial turbulence associated with the determined effort to
reduce inflation during the early 1980s might have been avoided, and monetary
targeting might have proved more successful throughout the period.
More generally, it may be argued that, in conducting a discretionary monetary policy, the Federal Reserve generally needs to pay considerable attention,
in a careful and sophisticated way, to the behavior of monetary aggregates.
Some prominent monetarists have suggested that an “adjusted monetary
growth rule” would provide an especially valuable guide for monetary policy.2O
The adjustments would take the form of a moving average correction for
20. Allan Meltzer and Bennett McCallum are leading advocates of some form of adjustable
monetary rule. Meltzer’s views are presented in several papers (see, e.g.,Meltzer 1987, 1991). For
McCallum’s arguments, see McCallum (1988).
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Michael Mussa
changes in the relation between monetary growth and the rate of growth of
nominal GIW. The virtue of such a “rule” is that it would help prevent the big
errors of monetary policy: avoiding the persistent declines in the money supply
that contributed to the Great Depression of the early 1930s and avoiding the
excessive monetary growth that contributed to the rise of inflation in the 1960s
and 1970s.
At least in my view, the usefulness of such a monetary rule is not as the sole
guide to the operational conduct of monetary policy but rather as a mediumterm indicator that policy may be deviating from the desired course. The “rule”
provides a warning signal against the danger of too much emphasis on interest
rates and on shorter-term economic developments and forecasts in governing
the conduct of monetary policy.
To illustrate the possible virtue of giving somewhat greater emphasis to
monetary growth rates in guiding the medium-term conduct of monetary policy, it is relevant to examine, retrospectively, whether this might have improved
economic performance. Because demand for the narrow monetary aggregate
MIA (= old M1) is less sensitive to movements in interest rates than the
broader aggregates,it is convenient to focus attention on this narrow aggregate.
As was recognized at the time, it is necessary to adjust for the downward shift
in demand for M1A when interest-bearing transactions accounts (not included
in M1A) became widely available to households in 1980 and 1981. With these
adjustments, M1 appears to provide useful indications that might have guided
improvements in monetary policy.
In the late 1970s, MIA was growing at rates that indicated a relatively easy
monetary policy, especially in light of the normal upward trend (for the preceding twenty-five years) in the velocity of this aggregate. Giving a little more
weight to the growth of M1A in determining monetary policy in the late 1970s
would have suggested a somewhat earlier and more vigorous attack on inflation. The slowdown in the growth of MIA in the autumn of 1979 and the
winter of 1980 provided an appropriate indication of the necessary tightening
of monetary policy to combat the surge of inflation at that time. The sharp
upturn of growth of M1A during that summer and early autumn of 1980 provided an accurate indication of the Federal Reserve’s unfortunate retreat from
the battle against the demon of inflation. Making appropriate allowance for the
shift of households out of traditional demand deposits, the very tight monetary
policy from November 1980 to July-August 1982 is also clearly indicated by
the behavior of MIA. Had the Federal Reserve taken this indicator more seriously, it would not perhaps have pursued quite such a tight policy for quite so
long, and the recession of 1981-82 might not have been quite as deep and quite
as long.
The sharp increase in the growth rate of M1A in late summer and autumn
1982 dramatically illustrated the shift to a much easier monetary policy. The
gradually declining, but still moderately high, rate of growth of M 1A until the
spring of 1984 points to the continuation of a relatively easy monetary policy,
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Monetary Policy
while the sharp downturn in M1A growth later in the year indicates the brief
period of monetary tightening. In retrospect, it seems that a modestly less easy
monetary policy during late 1982 and 1983, which would have contributed
somewhat less to the extraordinarily rapid pace of economic expansion from
late 1982 to mid-1984, might have been appropriate. It might also have obviated the need for monetary tightening during 1984 that hit the economy at
about the same time as the natural forces of economic recovery were abating.
During 1985 and especially 1986, the rapid growth of MIA indicated a substantial easing of monetary policy. Then, the sharp decline in the growth of
M 1A indicated an abrupt tightening of monetary policy during the first half of
1987, and the negative growth of M1A indicated further tighteningjust before
the stock market crash. After a brief period of easing during the first few
months of 1988, the growth rate of M1A indicated a very significant tightening
of monetary policy from April 1988 through July 1989, followed by a modest
degree of easing in the last quarter of 1989. Looking back at the very rapid
real growth of the economy during 1987 (which is apparent especially in the
revised data), it is relevant to ask whether a somewhat less expansionary monetary policy during 1986 might not have contributed to a more moderate pace
of economic growth during 1987, thereby alleviating some of the need for
monetary tightening in 1987 and conceivably in 1988-89. Again, taking more
seriously the behavior of M1A as a guide for monetary policy might have contributed to a somewhat smoother, more sustainable course of economic
expansion.
To avoid misunderstanding, it should be reemphasized that the issue is not
whether the Federal Reserve should have set a specific target for the growth of
MIA as the operational guide for monetary policy in the 1980s. Rather, the
question is whether, at the margin, monetary policy might have been improved
if somewhat more attention had been paid to the signals provided by the growth
rate of MlA, within the context of the array of factors that guided Federal
Reserve policy. Indeed, as previously discussed, rigid targeting of growth rates
of monetary aggregates can lead to serious difficulties in the turbulent economic and financial environment of a determined assault on entrenched inflation. In these situations, the Federal Reserve faced tough decisions about how
long to pursue a tight monetary policy in order to curb inflation, without highly
reliable indicators of the actual tightness of its policy or of the likely future
course of the economy. Careful judgment, rather than a mechanistic rule, was
required to determine the most appropriate policy. Of course, with an appropriate monetary policy, difficult decisions about harsh actions to combat rising
inflation should be an infrequent necessity. However, there is no guarantee, and
no automatic rule, that assures that such decisions can always be avoided or
that they will always be made wisely.
As the experience of the 1980s makes clear, real people and their elected
representatives care a good deal about the growth of the economy, about the
level of employment, about the rate of inflation, and about the level of interest
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Michael Mussa
rates. Intrinsically, they care little about growth rates of monetary aggregates.
The only occasion on which the monetary growth rates became a subject of
significant public interest was during the early 1980s, when the Federal Reserve was believed to be paying significant attention to these growth rates in
determining its policy with respect to interest rates. Once the Federal Reserve
effectively abandoned operating procedures that attempted to achieve targeted
growth rates for monetary aggregates, general public interest in monetary
growth rates waned rapidly. The implication is that, so long as monetary policy
contributes to acceptable behavior of the economic variables that really matter
to real people, the Federal Reserve is unlikely to be held publicly accountable
for deviations of monetary growth rates from specified targets. Rather, such
technical issues regarding the conduct of monetary policy-important as they
may be-will remain primarily the domain of specialists who analyze and
assess the Federal Reserve’s performance.
Ultimately, it is the performance of monetary policy with respect to its influence on growth, employment, inflation, and other economic variables of real
importance for which the Federal Reserve can and should be held responsible.
The task of assessing the Federal Reserve’s performance, however, is not
simple-primarily because the Federal Reserve’sjob is not simple. Monetary
policy is far from the only important influence on economic activity or even
on inflation. The Federal Reserve must conduct its policy without precise information about the ongoing behavior of the economy or, especially, about its
likely future behavior. On some occasions through no fault of its own, and on
some occasions because of past errors of its own policy, the Federal Reserve
will confront choices with no happy outcomes. Moreover, even when monetary
policy is tuned appropriately, a tension always exists between good arguments
that the policy should be a little tighter and good arguments that it should be a
little easier. Almost inevitably, the Federal Reserve will get somewhat more
than its fair share of praise when the economy performs well and somewhat
more than its fair share of blame when the economy performs badly. Fortunately for u s all, for most of the decade of the 1980s, the Federal Reserve has
been more deserving of thankful applause than of harsh criticism.
References
Barro, Robert, and Robert Gordon. 1983. Rules, discretion, and reputation in a model
of monetary policy. Journal ofMonefary Economics 12, no. 1 (July): 101-21.
Barro, Robert, and Xavier Sala-i-Martin. 1990. World real interest rates. NBERMacroeconomics Annual, 15-6 1.
Blanchad, Olivier, and Lawrence Summers. 1984. Perpsectives on high world real interest rates. Brookings Papers on Economic Activity, no. 2:273-324.
Feldstein, Martin. 1986. The budget deficit and the dollar. NBER Macroeconomics Annual, 355-92.
Greider, William. 1987. Secrets ofthe temple. New York: Simon & Schuster.
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Monetary Policy
Karamousis, Nicholas, and Ramond Lombra. 1989. Federal Reserve policy making:
An overview and analysis of the policy process. Camegie-Rochester Conference Series on Public Policy 30 (Spring): 7-62.
Kydland, Finn, and Edward Prescott. 1977. Rules rather than discretion: The inconsistency of optimal plans. Journal of Political Economy 85, no. 3 (June): 473-91.
McCallum, Bennett. 1988. Robustness properties of a rule for monetary policy.
Camegie-Rochester Conference Series on Public Policy 29 (Autumn): 179-203.
Meltzer, Allan. 1987. Limits of short-run stabilization policy. Economic Inquiry 25
(January): 1-14.
. 1991. The Fed at seventy-five. In Monetary policy on the 75th anniversary of
the Federal Reserve System, ed. M. Belongia, 3-65. Boston: Kluwer.
Tobin, James. 1980. Stabilization policy: Ten years after. Brookings Papers on Economic Activity, no. 1 : 19-7 1.
2. PaulA. Volcker
Martin Feldstein asked me to comment on some of the significant events in
monetary policy during my tenure as chairman of the Federal Reserve. I think
that there are five periods that deserve particular comment: the Federal Reserve’s adoption of a more monetarist approach to policy-making in 1979; the
credit controls and recession of 1980; the relaxation of monetary policy beginning in late 1982; the Plaza Accord in September 1985; and the Louvre meeting in February 1987.
Let me begin in late 1979, when I went to Washington. Michael Mussa’s
background paper accurately describes the setting for monetary policy at that
time. Inflationary expectations seemed to be rising, as there was little confidence in the financial markets that the Federal Reserve would effectively restrain an increase in inflation. One part of the problem, I believe, was that
banks had lost any fear that they might ever be unable to raise funds for lending. The interest rate limit for large certificates of deposit had been removed
in June 1979, and the banks thought that there was no constraint on their ability
to obtain credit. Although the cost of funds to banks was high, the inflationary
environment meant that the banks did not let this high cost deter them from
continued lending.
Ironically, despite these inflationary expectations, there was also an expectation that a recession was starting. For several months before the summer of
1979, the Federal Reserve staff had been projecting that a recession would
begin shortly.
Then the Federal Reserve raised the discount rate twice between July and
September 1979. Unfortunately, although these discount rate increases raised
short-term interest rates somewhat, they had virtually no effect on the psychological environment. In fact, and much to my surprise, the second increase was
actually counterproductive. That increase was adopted by a four-to-three vote,
and of course the votes are announced. The market interpreted the close vote
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Paul A. Volcker
as implying that the Federal Reserve was obviously not going to undertake
any further tightening measures. Ordinarily, I might have been sensitive to that
interpretation because one does like to have more of a consensus on shifts in
policy. In this case, however, I was not concerned because I knew that I had
three other votes if I wanted to tighten again. So it had not occurred to me in
advance that the closeness of the vote would be a problem.
This event was one of the things that persuaded me that the Federal Reserve
needed to pursue a strategy that would “shake up” the inflationary psychology
and introduce some constructive uncertainty in financial markets. The strategy
that we pursued-moving to a more monetarist approach to policy-makinghad been the subject of endless analysis and debate at the Federal Reserve, and
I had begun thinking about it earlier when I was still in New York. As I discussed the desirability of such a strategy as a means of dealing with expectations, there was enthusiastic support among both the Board members and the
district bank presidents. I think that it is fair to say that the Carter administration was not enthusiastic. Members of the administration argued that the Federal Reserve should not launch this uncertain new approach, with unknown
consequences, but should instead, if really necessary, tighten policy more severely in a more orthodox way.
Nevertheless, the change in policy was announced in early October 1979. I
thought that there were two great advantages of the monetarist approach, which
I had emphasized in some earlier speeches. First, it was a good way of disciplining ourselves. When we had announced that we were going to meet certain
money supply targets, and not by manipulating interest rates but by working
directly through the reserve base, we were committing a lot of prestige to that
commitment, and it would have been very hard to rationalize a retreat. Second,
it seemed to be a good device, given the spirit of the times, to convey what we
were doing to the public. We said, in effect, that the United States was experiencing high inflation that needed to be dealt with and that inflation is a monetary phenomenon. Thus, we were not going to try to reduce inflation by manipulating interest rates but were instead going to go directly to the money supply.
That seemed like a good way to explain what we were doing in a way that
people could understand and support.
I did not expect at the time that interest rates would move as much as they
did. Although we were working directly through reserves, we had established
a wide band for the Federal funds rate and had agreed to reconsider our actions
whenever the rate reached either end of this band. I thought that we should
take this band seriously, but most members of the Open Market Committee
were less conservative than I was on this point, and in the end the restriction
was not very meaningful. Whenever the Federal funds rate reached the end of
the band, there was a telephone meeting to ask whether the current policy
should be continued, and the answer was always yes. As time passed, even less
attention was paid to this band. So interest rates rose further and more rapidly
than I had expected, and it was a disappointment that there were no favorable
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Monetary Policy
expectational effects on long-term interest rates. While the money supply itself
behaved reasonably in line with our targets over the rest of 1979,it experienced
a great deal of volatility. Also, there was little visible effect at that stage on
either economic activity or inflation, the earlier projections of recession notwithstanding.
The next significant period for monetary policy was early in 1980. Inflation
had been running at a double-digitrate for several months, creating a true sense
of inflationary crisis. President Carter then proposed a budget with a deficit
that by today’s standards was small but was considered outrageously inadequate to the anti-inflationary challenge at the time. The budget was, in a sense,
withdrawn. The Federal Reserve took some tightening measures but delayed
others because we wanted to have a coordinated program with the new budget.
At this time, the president decided that consumer credit controls should be
imposed. He realized that some restraint on spending was necessary, and he
wanted the restraint to come not just from higher interest rates but also from
direct control over consumer credit. He became convinced that such a step
would send the message to the public that he was serious about reducing inflation.
We at the Federal Reserve resisted the imposition of consumer credit controls, partly because of the usual problems associated with rationing and partly
because consumer credit was not rising very fast and did not seem to be the
source of the inflationary pressures. There was a law on the books, however,
that said that the president could, in effect, give the Federal Reserve the authority to impose consumer credit controls. I thought that it would be awkward, to
say the least, for the president to give us the authority to impose controls and
then for us to say that we were not going to impose them anyway. In the end, I
felt that we could not talk the president out of the credit controls, and we had
to recognize that he was taking politically difficult steps to cut government
spending and was willing to accept and even support further monetary tightening without complaint.
So we agreed to impose controls on consumer credit, although we made
those controls as mild as we possibly could. We exempted anything to do with
housing and automobiles, which are by far the most important elements of
consumer credit. In effect, we put a tax on credit cards, a psychological gesture
that we thought would not amount to much. We were completely wrong, however, as the idea of cutting back on consumer credit apparently touched a guilty
nerve in the American public. The country went immediately into recession,
with the economy declining at a faster rate than we first realized.
Businesses selling consumer goods that were usually sold on credit faced
huge sales declines even when their products were not actually covered by the
credit controls. I recall some recreational vehicle dealers who had a two-thirds
decline in sales from one week to the next. The result was that the economy
dropped precipitously, and I realized in retrospect that I had never seen anything like it.
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Paul A. Volcker
We soon discovered that the money supply was dropping precipitously at
the same time. We were providing reserves at a rate that normally would have
sustained a 3 or 4 percent annual increase in the money supply, but in fact the
money supply actually declined for a month or two at a high annual rate. Only
later could we hypothesize not only that consumers were refusing to take on
additional credit, but also that they were repaying their outstanding credit card
balances because they felt that it was the patriotic thing to do. The repayment
was accomplished by a reduction in bank account balances, which created a
totally artificial decline in the money supply.
This decline in the money supply provoked a chorus of comments from
economists-monetarists and Keynesians alike-to the effect that the Federal
Reserve needed to provide additional reserves to the banking system. At the
same time, of course, there was a very steep decline in economic activity for
one quarter. So we took off the credit controls as soon as we could because I
thought that they were inappropriate when the economy was in a recession.
I think that there was no sense during the summer of 1980 that the economy
was recovering. I remember meeting at that time with a group of leading bankers who were in Washington for some other purpose. I was starting to think
that the sinking spell in the economy was ending, although I had no sense of a
strong recovery. I asked the bankers whether they thought that they might look
back in October or November and say that by the end of September the economy was reviving. Not one of those bankers said that they thought that that
was at all possible. In fact, while we were having the meeting, the economy
had already been expanding for a month or two, and quite a lot of momentum
soon developed.
The money supply also began to increase during the summer, although from
a very low level. Initially, we did not move to restrain the rebound in the money
supply because the level remained well below our targets. We did take some
action beginning in August, but many people argue in retrospect that we did
not act aggressively enough to restrain the growth of money in the latter part
of 1980. The fact is that, for some months, neither we nor our subsequent
critics realized that the economy was rebounding as fast as it was. All the staff
projections of the money supply were for modest increases; in fact, we ended
up with very large increases. This put us in the awkward position of having to
tighten money in the face of a presidential election campaign. Jimmy Carter
was complaining (although in a very limited way, to his credit) about “monetarism” and rising interest rates, while Ronald Reagan was complaining about
the wild expansion of the money supply. We did increase the discount rate
around the end of September, which is historically the closest to an election
that the discount rate has ever been increased.
In retrospect, however, monetary policy seems too expansionary during this
short period. The money supply rose rapidly until October or November, when
we tightened more aggressively and here able to get it under control. It was in
a way a mostly wasted year restoring credibility in the attack on inflation. The
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main reason, it seems to me, was the complications introduced by the credit
controls. This is a useful lesson. The unexpected psychological repercussions
of that inherently mild action-the way the American public responded at that
time to that gesture-were completely out of proportion to what we expected.
We would not have had such a steep drop in the money supply or in the economy except for the controls.
The next interesting event was the easing of monetary policy in 1982. The
recession had begun in mid- 1981, but we did not adopt a strongly expansionary
monetary policy until the summer of 1982. There were several reasons for our
cautious stance in the first half of that year. First, there was a big jump in the
money supply around the beginning of 1982 that carried it above our targets.
Under the new approach and operating techniques, that development was not
conducive to any aggressive moves to ease money. Second, although the economy was in a recession, inflation had not fallen very much by early 1982.
Third, there were substantial expectations, generally shared within the Fed,
that the economy would begin to expand in the second quarter of the year, I
believe that the initial estimates of the second quarter did in fact show a small
expansion, although that was later revised away. In studying the history of
monetary policy, one must remember the difference between the revised figures available now and the unrevised figures available at the time. In the spring
of 1982, we were operating in an environment in which we thought that the
economy was probably beginning to recover, and the money supply remained
somewhat above our targets.
However, this confidence in an imminent expansion became more and more
questionable as the spring proceeded. The financial markets were under increasing pressure as well; this was an important background factor, although
not the driving force, behind our eventual decision to ease. Sometime in July,
as I recall, after the money supply had been stable for a long period, it finally
fell back into our target ranges after its big jump at the beginning of the year.
At this point, we decided that we could ease credibly, and we made some limited easing movements, the effects of which on interest rates were greatly amplified by market expectations, producing a solid decline. The stock market
surged.
By the fall of 1982, the money supply began rising rapidly again. The money
supply figures were clearly being distorted by the new money market accounts
and other institutional changes, so this provided the occasion for an announcement that we were not going to follow M1 as religiously as we had been doing.
In particular, we were not going to institute contractionary policy simply because the money supply figures were rising, and, in fact, we made another
important easing move in the fall. By the end of the year, a strong recovery was
under way.
Now let me turn to the Plaza Accord of 1985. This is an important event to
discuss because the implications of the accord for monetary policy were the
opposite of what is commonly thought to be the case.
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Paul A. Volcker
The dollar had reached a peak in early 1985, and there was continuing debate both in the United States and overseas about exchange market intervention. Treasury Secretary James Baker and Deputy Secretary Richard Darman
were more inclined to intervene than previous Treasury officials had been, and
the meeting at the Plaza was largely at their initiative. I well understood the
arguments for reducing the value of the dollar and had pleaded many times
earlier for agreement on coordinated intervention.But I also held a good, traditional central banking view that countries deliberately depreciating their currencies often run afoul of inflation. I feared that the dollar decline might get
out of hand, and I was simply not enthusiastic about an official doctrine that it
is good to depreciate one’s currency. So I wanted the decline in the dollar to be
pursued without undue aggressiveness, and we had great arguments about how
to do that. In the end, I think that my views about how to implement the intervention were largely accepted.
But the central question for today is, What were the implications of the accord for monetary policy? I read a lot of analysis that says that the Federal
Reserve would have preferred to tighten policy for domestic purposes but was
forced into a looser policy in order to help bring down the dollar. That is not
true. By 1985, I was quite concerned that the U.S. economy was slowing down,
and the Japanese and European economies were very sluggish as well. There
was no doubt in my mind that it was not the right time to tighten policy. In
fact, it was the absence of any need or desire to tighten that provided a “green
light” for the Plaza Agreement. Indeed, there was substantial argument with
the Fed in favor of loosened monetary policy for domestic purposes, but one
reason that I opposed that action was because I did not want the dollar to fall
in value too suddenly or confidence in our anti-inflationary resolve to be undercut. Thus, concern about the value of the dollar caused monetary policy to be
shaded more on the tighter side during late 1985 than on the easier side, although that shading was evident in a refusal to ease rather than an actual tightening. I emphasize this point because it is just the opposite of what most commentators were saying at the time and have been saying more recently as well.
Finally, let me discuss the Louvre Accord of early 1987. During the summer
of 1986, James Baker and I engaged in an ongoing public dialogue about the
appropriate value of the dollar. He would say that he wanted the dollar to fall
in value. My sense was that it had fallen enough, and I was afraid that it would
be too weak, so I would testify the following day that I thought that its current
value was just fine. We finally decided that he could say what he wanted and I
could say what I wanted, and this was not particularly acrimonious because it
had a favorable side effect-while the dollar continued to decline some, the
contrasting approaches injected some uncertainty into the market, which prevented matters from getting out of hand. As the dollar remained weak, however, Treasury Department officials became more concerned about it. They arranged for the Louvre meeting, which was designed to reach an international
consensus to stabilize exchange rates.
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Monetary Policy
At neither the Louvre meeting nor the Plaza meeting was there any explicit
discussion of monetary policy. This may be surprising from the standpoint of
economic analysis, but it is not surprisingly bureaucratically or as a matter of
internationaldiplomacy. The central bankers had no desire to discuss monetary
policy in that essentially political setting at the .risk of tying their hands in the
future. And the finance ministers felt that they could not press the point. The
Germans in particular were very punctilious, with the people from the Finance
Ministry believing that it was the Bundesbank’sjob to discuss monetary policy.
The central bankers, quite naturally, preferred to discuss monetary policy issues “outside the room” and in other forums, but often they were not very
explicit even then. In fact, big changes in monetary policy were not an issue at
the Louvre. There was a lot of communication on a continuing basis afterward,
but it was more in regard to intervention and exchange rates than to monetary
policy per se. I think that everyone understood that the Plaza and Louvre
agreements obviously had consequences for monetary policy, but that was all.
At both the Plaza meeting and the Louvre meeting, there were very explicit,
painstakingly detailed discussions about who would intervene, in what
amounts, and under what circumstances. Most of this discussion irritated me
because I thought that it was very artificial-one cannot anticipate all the possible contingencies and determine who should do what in response. Nevertheless, there was a lot of discussion of that sort.
3. James Tobin
Speaking about Paul Volcker right after Paul Volcker, I am not in an enviable
position. Imagine an academic critic following Douglas MacArthur in a retrospective discussion of the general’s campaigns.
I shall discuss only briefly the three years from October 1979, the period of
serious quantitative medium-run targets for monetary aggregates and of shortrun operating targets for quantities of reserves. History will confirm the praise
that Paul Volcker earned from his contemporaries for his resolute generalship
of the war against the inflation of the late 1970s. The recessions did not reduce
inflation to zero, but they did lower it to a comfortable rate, 4-5 percent, which
proved to be stable during the subsequent cyclical expansion.
In 1979-80, many economists contended that the way monetary policymakers could bring about a relatively rapid and painless disinflation would be to
announce strict monetarist targets and operating procedures and to commit
themselves to stick with them regardless of what happened to business activity
and employment. Thus, business managers and workers would be put on notice
that their livelihoods and jobs depend on their own price and wage decisionsthey must disinflate. This popular academic view may have influenced the cli-
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James Tobin
mate of opinion in the Federal Reserve System and the financial markets. I
gather that it was not as important in Volcker’s own thinking as the need to
obtain and display consensus in the system for a policy move appropriate to
prevailing economic conditions.
If a “credible threat” was intended in the October 1979 revolution, it was
attenuated by the policy roller coaster in 1980, severely criticized by Mike
Mussa in his background paper and unapologetically reviewed by Paul in his
remarks. Why Carter’s credit controls were so powerful a restraint on aggregate
demand and on money supplies remains a mystery. Evidently, their effects both
on imposition and on removal greatly confused the Fed. Anyway, beginning in
September 1980, a determined monetarist policy was followed for nearly two
years. Did the policy make the disinflation faster and less painful than it would
have been otherwise? The economic literature renders a mixed verdict. Certainly, it took substantial pain and suffering, not just threat, to get wage and
price inflation rates down.
Was there any way to limit the cost? Some economists, myself included,
had suggested combining the announcement of a firm disinflationary monetary
policy with some variant of incomes policy, at least guideposts. There had been
a stab at incomes policy in the Carter administration in 1979, but it was abandoned just at the crucial time. Rumor was that this decision was related to the
contest for the Democratic presidential nomination, specifically to the position
of organized labor. No incomes policy was conceivable in the new administration, although President Reagan’s tough stand against the air traffic controllers
in 1981 taught an exemplary lesson. One could say t!!at the Fed itself was
carrying out an incomes policy, albeit one that worked via actual pain and cost
rather than by conjectural fears.
I hope that history will give Paul and his colleagues the praise that they
deserve not only for fighting the war against inflation but also for knowing
when to stop, when to declare victory. They reversed course in the summer of
1982, probably averting an accelerating contraction of economic activity in the
United States and financial disasters worldwide. Many observers, knowing that
the Fed takes seriously its responsibilities for financial stability, have assumed
that the Mexican debt crisis and other financial threats were the main considerations in the Fed’s decisions in 1982. According to Volcker, however, domestic
nonfinancial business conditions were the main concern of the Federal Open
Market Committee (FOMC).
I know that there are some hawks who thought then and think now that the
anti-inflationcrusade should have been pursued to the bitter end and that there
are some who would resume now the push to zero inflation. I think that it was
an act of genius, worth trillions of dollars of GNP-yes, real GNP-to have
led the country to regard 5 percent inflation as zero, and I think that it is mischievous to rock the boat now.
The monetary management of the expansion of the last eight years-perhaps this record expansion has ended or is about to end-is my main topic.
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For the management of aggregate demand, monetary policy has been the only
game in town since 1981. The Reagan administration disabled fiscal policy as
a tool of macroeconomic stabilization and dedicated it wholly to other goals,
as discussed in other sessions of this conference. Structural budget deficits far
beyond previous peacetime experience clouded the environment to which the
Fed had to adapt. No doubt the economic and political implications of the
federal budget complicated the Fed’s decision problems. There were other new
complexities and uncertainties: dramatically increasing international capital
mobility; Latin American and other Third World debts; structural and regulatory changes in American banking and finance; insolvencies, threatened and
actual, among American financial institutions.
Despite these handicaps, the Fed has been quite successful. Volcker and
company, and then Greenspan and company, restored the reputation of finetuning and made it into a fine art. The proof is in the pudding. The economy
grew steadily, if sometimes slowly, and eventually recovered the ground lost
in the recessions. In 1988-89, unemployment was lowered well below what
economists considered the lowest inflation-safe rates ten years earlier. Finally,
after managing a “soft landing” at this new and lower nonaccelerating-inflation
rate of unemployment (NAIRU), for the last two years the Fed has managed
to steer the economy between the Scylla of price acceleration and the
Charybdis of recession. I don’t know how long that will be true, but it is true
so far.
Demand management cannot take major credit for the improvement in the
NAIRU, except that the previous deep recession may have helped discipline
subsequent wage- and price-setting practices. Sharper foreign competition
helped, a thin silver lining to the dark cloud of dollar appreciation. The decline
in oil prices prior to August 1990 was a welcome contrast to the 1970s. whatever cleared the path for expansion, the Fed does get credit for following the
path into new territory, cautiously keeping the recovery going as long as inflation remained well behaved.
For the improved price performance of the 1980s, Mussa gives important
weight to the new macroeconomic policy mix, loose fiscal policy and tight
money. He echoes previous rationales for this combination. The argument is
that the 1982-86 currency appreciation lowered the inflation rate associated
with a given outcome in real output and employment. I am still skeptical. For
the United States, the impact of appreciation on overall price indexes is small.
Besides, it is temporary, essentially a loan from other countries that must be
paid back. Later, the currency has to be depreciated, and the borrowed price
reduction has to be reversed. Even in the short run, the gain from an appreciation is one shot; it lowers not the rate of inflation but the level of price indexes.
The policy mix in question has serious costs in long-run growth and foreign
indebtedness, costs that dwarf any small short-run macroeconomic advantages.
I have no inside information about how the Fed has done its fine-tuning. The
interpretation that follows is simply inference from an outsider’s observations.
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James Tobin
The new Fed monetary regime, beginning in the fall of 1982, changed both
medium-run targets of policy and operating procedures. Although target
ranges for intermediate monetary aggregates are still voted on and announced,
as required by law, they have lost importance, as the markets know very well
(see Mussa’s figs. 2.8 and 2.9).
The Federal Reserve recognized that intermediate monetary aggregates had
lost whatever meaning they had because of regulatory and technological
changes in the financial industries. Downgrading the monetary targets finessed
at least one source of error in monetary policy, unexpected (or even systematic)
changes in velocity. Mussa’s figure 2.10 shows what happened to M1 and M2
velocities. Liberated from the Ms, the Fed is enabled to respond to shocks that
change velocity but not the aggregates and is excused from responding to M
changes that simply reflect velocity shocks. Tactically, in 1982, the changing
and uncertain meanings of the Ms gave the Fed some cover for making changes
in policy substance and operating procedure that Paul and his colleagues
wanted to make anyway.
The Fed has aimed directly at observed and projected macroeconomic performance, as measured not by monetary aggregates but by variables that matter: real GNP growth; unemployment, excess capacity, and other indicators of
slack; wage and price inflation. The weights on different measures of performance are not explicit; indeed, they doubtless differ among members of the
Open Market Committee. The bottom line is likely to be some agreed on or
compromise range for real GNP growth, higher or lower depending on the
weights the committee is putting on the other variables.
Short-run operating instruments are no longer reserve quantities but, as in
pre-1979 days, Federal funds rates. The differential between the funds rate and
the discount rate reflects the pressure on the banks’ reserve positions. Like
most controllers, the Fed is a feedback mechanism, changing its instrument
settings in response to discrepancies significant in size and duration between
actual readings and projections of its target variables, on the one hand, and
desired target paths, on the other.
Not surprisingly, Federal funds rates, and other interest rates as well, have
been less volatile since 1982 than in the preceding monetarist regime. Paul
admits that he was astounded by their volatility in 1980-82. Most of their recent volatility has been deliberate policy. When the Fed saw aggregate demand
growing too slowly, the FOMC lowered the funds rate substantially (down 564
basis points in six months from July 1982). When demand was perceived to be
growing too fast, the FOMC raised the rate (up 205 basis points in six months
from February 1984). Likewise, the funds rate was lowered 163 points in the
seven months from February 1986 and raised 210 points in the eight months
from July 1988. Other interest rates moved in the same directions, longer rates
of course by fewer points (see Mussa’s fig. 2.4).
In retrospect, the tightening in 1984 looks excessive to me and too long
maintained. The recovery was little more than a year old, and there was plenty
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of slack left in the economy. At the time of the February 1984 “Monetary
Policy Report,” the Board believed that real GNP had grown 6 percent from
1982:4, then thought to have been the recession bottom, to 1983:4 and that
growth had slowed to 4.5 percent in 1983:4. The Fed reported that 1983 growth
was in considerable measure due to rebuilding of inventories. The unemployment rate was said to be down 2.5 points, but it was still about 8 percent. Wage
and price inflation was still abating. Yet the Fed was aiming for only 4.5 percent growth in 1984, fourth quarter to fourth quarter-they got it, now revised
to 5 percent. (This is the only time that I found so explicit a target in a “Monetary Policy Report to Congress.” Generally, the growth target is unstated or is
implicit in the FOMC members’ projections. In his remarks, Paul warned us
against reading any policy intentions into those projections.)
In most postwar recoveries, growth was 6 percent or better in the first year.
I have never found convincing the “speed limit” theory, which argues that high
growth rates are dangerously inflationary even in very slack economies. Demand management, I think, should aim for high growth at the beginnings of
recovery and gradually reduce stimulus as the margin of economic slack declines. The Fed’s foot was a bit heavy on the brake.
I mention this episode because it did unintended and unexpected longlasting damage. The return of double-digit short interest rates in mid-1984,
raising long-term bond rates above 13 percent again, ratcheted the dollar up
another big notch (20 percent nominal, 19 percent real, in the multilateral
trade-weighted index). I realize that, as Paul Krugman convincingly argued,
there must have been significant speculative content in the appreciation of the
dollar. But U.S. interest rates had a lot to do with it. The merchandise trade
deficit grew from $21.7 billion in 1983:4 to $29.3 four quarters later, the current account deficit from $18.3 to $30.0. Reversal of the deterioration proved
to be a slow and difficult process, even after the dollar’s exchange value fell.
By 1980, economists inside and outside the Federal Reserve and the Treasury understood the qualitative role of exchange rates, capital movements, and
trade imbalances in the transmission of monetary measures-and fiscal measures too-to the economy in a world of floating exchange rates and mobile
financial funds. Qualitatively, things happened the way our theory said they
would. But I guess that no one, even in the Fed’s international shop, foresaw
how large these effects could be, how long they could persist, and how difficult
they might be to reverse.
The drag of the import surplus was one reason that the recovery of real GNP
proceeded even more slowly in the two years after 1984,3.6 percent in 1985
and 1.9 in 1986, while unemployment hovered around 7.0 percent. Only in
1987-88, after the cautious easing of 1986 finally took effect, was the recovery
completed, five and a half years after it had begun.
Real interest rates averaged 400 or 500 basis points higher in the 1980s
recovery than in previous postwar expansions. This is the proximate cause of
several well-known adverse developments in the U.S. economy and the symp-
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James Tobin
tom of others. Like most people in this room, I place most of the blame on
federal fiscal policy. But the Fed could have lowered rates sooner and further
in the period 1984-87.
I tell monetary policy skeptics like my friend Bob Eisner that we could have
had-indeed, we would have had-the same recovery in the 1980s without the
extraordinary fiscal stimulus, the same performance in GNP and employment
without the negative by-products. I have based this claim on the generous interpretation of Fed policy that I have given above. Assuming that the Fed’s targets
for macroeconomic performance would have been the same had fiscal policy
been pre-Reagan normal, I say that the Fed had plenty of room to lower interest
rates in pursuit of those targets and would have used it. Maybe, in fact, sound
fiscal policy would have made the Fed more expansionary. Maybe our central
bankers held back at times in hopes of sending a message about fiscal policy
to the president and Congress.
I am still saying these things, now to people who wony whether budget
correction will cause recession. I hope I am right. The Fed might have to act
faster, in larger steps, than they did in 1984-86. Twenty-five basis points every
FOMC meeting would not be enough.
Sometimes, I am afraid, defense of the dollar has been given more weight
than it deserves. I am not refemng to the fall of 1979, when Paul tells us that
the dollar’s weakness and the complaints of major foreign central bankers simply reinforced the sufficient domestic reasons for a contractionary move. But
supporting the dollar was a consideration in 1984 and again after the Group of
Five agreed at the Louvre in early 1987 that the 1985-86 depreciation had
gone far enough. (According to Paul, this was Treasury policy, not his preference. The idea that exchange rate policy is the province of the Treasury and
that monetary policy is the province of the Federal Reserve seems dangerously
anomalous, given that the two policies are essentially one and the same.) Interest rates to support the dollar contributed to the slowdown in 1987 and perhaps
to the stock market crash in October. Following the crash, Greenspan and his
colleagues eased decisively and let the dollar fall, with good macroeconomic
results.
Dollar defense may be a consideration again now, when domestic demand
expansions and tight monetary policies are raising interest rates in Japan and
Europe. I see no good reason to oppose a depreciation of the dollar when lower
interest rates are appropriate to domestic demand management, particularly
when there is room in the economy for more net exports. How will we get the
capital inflow that we need to “finance” our trade deficit if our interest rates
are lower than those overseas? If it takes a dollar low enough to make investors
around the world believe that it is going to rise, so be it.
As early as the spring of 1982, I suggested a tripartite accord-White
House, Congress, and Fed-to shift the policy mix to tighter budget and easier
money. It was a good idea then, and it has been a good idea ever since.
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Summary of Discussion
Paul Volcker began the discussion by responding to several points made by
Tobin. First, he addressed the extent to which the Federal Reserve worries
about financial markets as well as about the economy. He thought that most
people at the Fed focus on the economy, although in 1982 he had persuaded
them to start thinking about the financial system as well. He and the president
of the New York Federal Reserve Bank had womed more about the financial
markets than other people had.
Next, Volcker agreed with Tobin that different members of the Federal Open
Market Committee (FOMC) weigh various factors differently in choosing the
appropriate monetary policy. This is why it is almost impossible to say what
weights the Federal Reserve as a whole was giving to the money supply and to
other indicators. Volcker thought that one reasen that the FOMC keeps returning to interest rate targeting, which is what they seemed to be doing again,
is simply that the rest of the committee never completely trusts the chairman.
With a money supply target, some members of the FOMC might be suspicious
that the chairman would use the small amount of leeway he has in week-toweek operations to produce a slightly different result than they want. With a
Federal funds rate target, this problem does not exist.
Third, Volcker disagreed with Tobin’s judgment about the degree to which
there had been a problem with monetary policy in 1984. The general mind-set
at the Federal Reserve had been that the Fed historically made the mistake of
tightening monetary policy too late in an expansion and was then forced to
tighten too abruptly. Perhaps that background contributed to the Fed sticking
to a tighter policy in the summer of 1984 longer than it really intended or, in
retrospect, than it should have. The lending market turned out to be tighter
than expected because banks were reluctant to lend to each other as freely as
they had in the past, and the result was double-digit interest rates. During July
and August, there was much disagreement on the FOMC about how to respond, if at all, and it was not until September, when the economy began to
look shakier, that monetary policy was finally relaxed.
Further, Volcker said that the Fed had paid attention to exchange rates in
1985 and 1986 and that he did not think that that had been a mistake. He added
that Japan and Germany were growing even more slowly than the United States
during that period and that he had felt that the burden was on them to expand
in the interest of the world economy. So he had devoted considerable effort to
encouraging them to expand so that the United States would not have to take
inappropriately strong expansionary action itself.
Finally, Volcker remarked that he thought that there were signs that the Federal Reserve was going back to attempts to fine-tune the economy, deliberately
or not.
Martin Feldstein asked whether the Federal Reserve expected a recession to
occur in 1980 as a result of its change in monetary policy in late 1979.
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Summary of Discussion
Volcker responded that the Federal Reserve staff (like many others) had been
projecting a recession for a long time but that it had not yet materialized. Thus,
he thought that there was some risk of one occurring but that he was not at all
certain, as the economy seemed to be expanding despite the expectations and
people seemed to be willing to borrow and lend. Volcker said that he knew
that a recession would occur sooner or later, regardless of the short-term stance
of monetary policy, and that even now he is not sure whether the economy
would have had a recession in March and April if credit controls had not been
imposed. Volcker also noted that the White House had strongly urged (and
authorized) the credit controls to make a political point as a supplement to the
more traditional monetary restraint.
Feldstein questioned whether it was a natural thing that the economy had
turned around so quickly after the very sharp downturn in 1980. As Volcker
had described it, the credit controls induced a drop in money demand so that
interest rates fell automatically without any explicit action by the Fed. In response to lower interest rates, money demand increased, and the economy recovered, with the Fed just a passive player. Volcker clarified that the Federal
Reserve had taken the discretionary step of increasing nonborrowed reserves
on several occasions.
Feldstein asked how effective the 1979 “regime shift” had been in convincing financial markets that the Federal Reserve was serious about reducing inflation.
Volcker believed that the outcome of the regime shift was not as favorable
as he had expected or hoped. The Fed wanted to show banks that they did not
have an inexhaustible supply of money, so they ought to take more care about
the credit they were extending. This is the reason that the Fed put a special
reserve requirement on time deposit accounts in October. Yet the policy was
not as effective as hoped because of deep skepticism in the market. One indication was that people interpreted the fact that the Federal Reserve set monitoring ranges for the Federal funds rate as meaning that it was not really going to
follow the new policy. Volcker added that this was why he was really not sure
that there would have been a recession in March 1980 without the credit controls.
William Niskanen questioned the motivation of the Carter administration
when it asked the Federal Reserve to impose credit controls in March 1980.
Charles Schultze replied that he had thought that the rationale for the policy
was somewhat absurd. The Carter administration had been preparing an economic package that reduced the budget deficit by cutting social programs and
encouraged the Fed to tighten monetary policy. But parts of the administration
wanted a “liberal element” to combine with these conservative pieces, and the
AFL-CIO was urging them to use credit controls to reduce the flow of credit
without raising interest rates. So the Carter administration asked the Fed to
impose the controls. Schultze added that no one had anticipated the public’s
response-people tore up their credit cards and mailed them back, and there
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Monetary Policy
was a 40 percent drop in the monthly sales of big-ticket items. What was,
objectively, a relatively mild penalty on consumer loans unexpectedly turned
into a massive reduction in borrowing.
Paul K r u g m n noted that, in the discussion of budget policy, both Stockman
and Schultze concluded that the standard budget policy in the United States is
essentially an equilibrating one but that there were unusual events at the beginning of the 1980s that changed matters. For monetary policy, most people
would conclude that it normally has an inflationary bias, where the Federal
Reserve fights recessions earnestly and responds to inflations somewhat late.
But, in the early 1980s, monetary policy, like fiscal policy, was completely out
of character. Krugman wondered why this was possible. One explanation
might be the great intellectual confusion that was reigning in 1980. There was
the monetaristlrational expectations belief, for example, that, if you strongly
announced your willingness to suffer pain, you would not actually have to suffer it. Monetarism also gave the Fed the ability to say that it was simply targeting monetary aggregates and not actually planning on a recession.
Krugman also asked whether it was simply a “stealth tactic” for the Fed to
use the trappings of monetarism to pursue an essentially orthodox disinflationary policy.
Volcker replied that he thought that monetarist theory had been important in
shaping the monetary policy of the early 1980s, as the theory had gained respect from both the public and professionals. He thought that rational expectations theory had been much less important. Most crucial to the shaping of
monetary policy, however, was the fact that the general public was very upset
when inflation rates were 14-15 percent, and they realized that it had something to do with money. So they were more willing to tolerate measures to
reduce inflation by reducing money growth than when inflation did not seem
so troublesome.
Volcker asserted strongly that applying monetarist theory had not been a
stealth tactic. He believed that the Fed had used monetarism partly to discipline
itself and partly to take advantage of the public support for such a policy. It
was much easier to explain a monetarist policy to the public because he could
point out that money is related to inflation, so that, in order to restrain inflation,
the Fed needed to restrain the money supply. It seemed common sense that too
much money meant too much inflation-people had learned this in school and
had read it in the daily press. Volcker felt that it had been a very simple message, important to the explanation and support of policy.
James Tobin stressed Krugman’s question about the extent to which the Federal Open Market Committee had been influenced by the rational expectations/
monetarist doctrine in the late 1970s and afterward. The theory says that, by
making a credible threat that there will be pain and suffering about which the
Fed will do nothing, the Fed can accelerate disinflation without as much pain
and suffering. Had this theory been significant in the shift in policy during the
period 1979-82?
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Summary of Discussion
Volcker responded that there had been a hope that the theory would work in
a general way, but certainly no faith in the more extreme formulations. There
was a view that, if the Fed was credible enough, then short-term interest rates
might go up, but long-term rates would remain stable or even go down because
everyone had so much faith in the new, powerful anti-inflation program. In fact,
however, long-term rates went up.
William Poole said that one of the puzzles from the period 1979-82 is why
both long- and short-term interest rates were so volatile. One answer could be
that the markets did not gain confidence in the Federal Reserve’s conviction to
stick with its policy until the economy had suffered a considerable way through
the recession. But Poole did not believe that this explanationcompletely solves
the puzzle about why long rates were so volatile and followed short rates so
closely.
SchuZtze commented that perhaps Volcker sold himself a little short by denying the use of stealth in 1979. Schultze said that Volcker had been right, and
that he and William Miller [chairman of the Federal Reserve Board, 1978-791
had been wrong, about the tactic to be used when radically changing the stance
of monetary policy. For twenty-five years, the public had perceived the Fed as
sitting around deciding what interest rates were going to be the next month,
and the politicians saw the Fed as directly responsible for every quarter of a
percent rise in rates. In 1979, the Fed had to make massive moves in interest
rates, which would have been impossible had they tried to do it directly. Now
that the Fed no longer has to move interest rates a lot, they can go back to
targeting them.
Volcker responded that the Federal Open Market Committee really had no
idea that interest rates were going to rise to 19 percent. It was not as though
they decided that they wanted interest rates to go 19 percent and just announced the money supply figure that they knew was going to result in those
rates. Volcker had known that interest rates were going to go up, but, had he
known in advance that they would increase so much, he did not think that he
would have been able to convince the committee, or perhaps himself, to implement the same policy. He emphasized this point because he did not think that
the Federal Reserve can survive as an institution if people become convinced
that things are done by stealth. He felt that it is very dangerous for any institution that depends on people’s confidence to adopt policies on the basis that
they will fool people. He regretted the confusion on this point that had been
sown by later comments of some on the Open Market Committee itself.
Feldstein repeated Tobin’s statement that at some point the Federal Reserve
had stopped targeting the monetary aggregates and had made the true target
nominal GNP and the operating target the Federal funds rate. He asked Volcker
if this were true.
Volcker replied that, as the chairman, he had looked at both the economy
and the money supply figures and, as he had mentioned earlier, also at the
exchange rate and at financial markets when that seemed important. He
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Monetary Policy
thought that the real shift in the operating target was in October 1982, when
the Fed switched from total nonborrowed reserves to marginal borrowing. As
time passed, there was a lot of debate in the Federal Open Market Committee
(FOMC) between those who wanted to target interest rates directly and those
who wanted to stick with borrowing. People may say that it amounts to the
same thing because there is obviously a close relation, but it is not a perfect
relation, and at times the two targets imply different operational approaches.
Volcker added that he had opposed returning to interest rate targeting because it induces a great reluctance to adjust policy, as Schultze said. When one
is aiming directly at interest rates, it becomes a great decision to change them
by a quarter of a percent, so, to avoid this inertia, Volcker did not want to target
interest rates directly. Volcker said that it appears as though the Fed has gone
back to targeting interest rates directly and that this has in fact created more inertia.
Volcker then addressed the issue of whether real GNP was the Fed’s true
target. He said that he was never confident that there was a close relation between Fed policy and nominal or real GNP over relevant time periods for operational decisions. So, even though he monitored the acceleration or deceleration of GNP, it was really very hard to target as a short-term operational matter.
Volcker noted that the GNP numbers in the semiannual FOMC reports that
Tobin mentioned were really projections, not targets.
Tibin pointed out that it seems logical to interpret those projections as implicit targets, given that they come from “the pilot of the boat.” He went on to
say that he did not mean to imply that the Fed was using real GNP as the target
in any long-run sense but only that the Fed probably thinks of the economy
in the old-fashioned terms of slack and catch-up in relation to normal fullemployment growth. He noted that, although there are many economists in the
world today who do not think of the economy in those terms, he thought that
this is how the Fed was thinking of it during that period. So they based their
real GNP goals on the implications for full employment as well as for inflation
and the many other phenomena of concern.
Feldstein added that the Fed’s nominal GNP projections seemed to be more
or less consistent with traditional velocity relations and the Fed’s monetary
targets. Further, these nominal GNP projections were in line with the real
GNPhflation breakdowns forecast by the Fed. This suggests that, although
the Fed may not literally have had nominal GNP targets, it did have a sense of
the levels of nominal GNP, real GNP, and inflation that were consistent with
its monetary policy. It seems as though the level of nominal GNP really was a
central factor.
Volcker stated that the projections presented were not a set of forecasts that
had been debated. They were the independent projections of nineteen voting
and nonvoting members of the Federal Open Market Committee collected
before the meetings, and the projections rarely changed after the meetings.
Volcker added that people made projections of real GNP and of prices and
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Summary of Discussion
then added them up to get nominal GNP. Occasionally, these projections of
nominal GNP implied unusual velocity behavior when combined with the
monetary targets, but the implied velocity was never completely unrealistic.
Fred Bergsten responded that, despite Volcker’s description of the FOMC
meetings, people have found a closer correlation of monetary policy with nominal GNP than with anything else.
Geoffrey Carliner asked how important President Reagan’s support had been
to the Fed in its efforts to fight inflation in 1981 and early 1982. He also wondered whether the Fed would have received similar support from President
Carter.
Volcker said that he thought that the Federal Reserve had received fairly
good support from Carter. Despite the surge in interest rates, Carter mentioned
monetary policy only once during the 1980 campaign. The Reagan administration was very monetarist and did not care about interest rates, and it encouraged the Fed to pursue tight money in early 1981. The economy continued to
grow for a while despite the very high interest rates, but, when the recession
finally occurred, the administration stopped encouraging the restraint on
money, and a certain amount of sniping developed. Volcker said that he thought
that there were probably many people in the White House and at the Treasury
who tried to get President Reagan to criticize the Federal Reserve at that point
but that Reagan would not say anything bad about an anti-inflationary policy,
which was important.
Feldstein agreed that there were many people within the administration who
were taking every opportunity to criticize the Fed in 1983 and 1984, especially
as more and more private forecasters were predicting another recession. Nevertheless, President Reagan often took the opportunity at news conferences to
say that he was supporting the Fed.
Volcker added that, in his view, the most important single action of the administration in helping the anti-inflation fight was defeating the air traffic controllers’ strike. He thought that this action had had a rather profound, and,
from his standpoint, constructive, effect on the climate of labor-management
relations, even though it had not been a wage issue at the time.
Charls Walker asked the role of the presidents of the Federal Reserve Banks
in making policy. He wondered in particular whether they had supported or
hindered Volcker’s efforts from 1980 to 1982.
Volcker said that there had been a very harmonious board during that period.
People knew each other well and did not have very divergent views. Without
question, however, the most monetarist people were some of the bank presidents. So Volcker said that he instinctively knew that many of the bank presidents would be enthusiastic over the new policy because they had at times in
the past promoted something like that themselves.
Volcker also remarked that, although he received supportive comments on
monetary policy from the administration, their statements emphasized a gradual approach. After 1979, Volcker realized that it was not realistic to decrease
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Monetary Policy
the money supply gradually and expect that the economy would suffer no adverse effects. The Fed could not control the money supply that closely. Thus,
Volcker tried to remove the word gradual from all statements after 1979.
Bergsten opened the subject of how external factors like the dollar had influenced Volcker’s monetary policy. Although Tobin criticized Volcker for paying too much attention to the dollar, Bergsten thought that he had emphasized
it much less than in the popular political view. In particular, Bergsten wondered
about the role of external factors in Volcker’s 1979 decision. The dollar had
fallen sharply in late 1978 and remained precarious in 1979, and Volcker returned from the IMF meeting in Belgrade more quickly than had been scheduled. Had international events been, although not the cause of Volcker’s decision, the trigger for deciding to move at that point?
Bergsten also asked about the role of external factors in 1982 when the Fed
stopped targeting the monetary aggregates and went back to interest rate targeting. Some people suggested that the timing trigger had been the Mexico
debt crisis because of its implications for the U.S. banking system.
Volcker said that the weakness of the dollar in 1979 had been just one factor
in the whole inflationary expectationsflackof credibility picture. He had talked
with some of his central banking colleagues at the Belgrade meeting to see
how they would react to a strongly anti-inflationary monetary policy, and they
had encouraged him. But he had returned from Belgrade not because of any
great urgency caused by the meeting but because he felt that he should be back
to work on this program. Even more important than the Belgrade meeting itself
was a meeting with German Chancellor Helmut Schmidt during a stopover
on the return flight. Schmidt had said that the U.S. economy was in trouble
and that inflation was out of control. Shortly before that, Volcker had told
Schultze and William Miller about the monetary policy he was considering,
and the Schmidt visit may have been important in reinforcing the sense of
urgency.
As for the change in policy in 1982, Volcker noted that the first signals of
easing were in July, before the Mexican debt crisis erupted in the open. He did
think that the precariousness of the international situation had been a factor
but that domestic financial concerns had played a more important role.
On a related topic, Poole pointed out that the Plaza Agreement had committed the U.S. government to depreciate the exchange rate, requiring that interest
rates be kept low. He felt that this had put a constraint on what the Federal
Reserve could do. The market understood this constraint and took it as a signal
that monetary policy was going to be biased in an easier direction than would
otherwise have been the case.
Volcker recalled that he did discuss monetary policy with the secretary of
the Treasury at the time of the Plaza Agreement but that, since he had thought
that there was no reasonable prospect that the Fed would be tightening monetary policy for some months anyway, he had supported the agreement. Volcker
said that, if he had thought that the Plaza Agreement would constrain the Fed’s
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Summary of Discussion
decision making, his discussion with the secretary of Treasury would have
been different.
Feldstein asked if similar concerns were raised around the time of the Louvre Agreement and the period thereafter. Volckersaid that there must have been
some discussion at the time but that he did not remember it, probably because
it had not been a problem. It had not been discussed at the Louvre itself.
Feldstein then asked why the Treasury changed its policy regarding the exchange rate between 1985 and 1987. In 1985, the Treasury seemed eager to
push the value of the dollar down, whereas, in 1987, it wanted to keep the
dollar from declining any further. He wondered how much the decision to stop
the dollar from declining was due to Volcker’s concerns about an increase in inflation.
Volcker said that, under Secretary Don Regan, the Treasury Department had
taken it as a badge of national honor that the value of the dollar was high. They
did not want to intervene, no matter how high the dollar climbed. On the other
hand, Treasury Secretary James Baker and Deputy Secretary Richard Darman
seemed to dislike the large trade deficit, and they were particularly concerned
about the increasing protectionist pressures in Congress. Volcker thought that
this concern was really what had triggered the Plaza Agreement.
As for the decision to stop the decline of the dollar in 1987, Volcker said
that the Treasury was certainly aware of his concerns about inflation and more
pointedly than about the implications of a continuing fall in the dollar. He
thought that the Treasury had already become somewhat concerned about the
implications of further dollar decline. Also, the Treasury was concerned about
international cooperation from Japan, which it wanted to undertake an expansionary fiscal policy.